filings.toolsItem 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with the (1) unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, and (2) the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2022 included in the Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”), on January 31, 2023. This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to those identified herein, and those discussed in the section titled “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K filed with the SEC on January 31, 2023 and in Part II, Item 1A of this Quarterly Report on Form 10-Q and in our other SEC filings. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
Investors and others should note that we announce material financial information to our investors using our investor relations website (https://www.servicenow.com/company/investor-relations.html), SEC filings, press releases, public conference calls and webcasts. We use these channels, as well as social media, to communicate with our investors and the public about our Company, our services and other issues. It is possible that the information we post on social media could be deemed to be material information. Therefore, we encourage investors, the media and others interested in our Company to review the information we post on the social media channels listed on our investor relations website.
Our free cash flow measure included in the section entitled “Key Business Metrics—Free Cash Flow,” is not in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). This non-GAAP financial measure is not intended to be considered in isolation or as a substitute for, or superior to, financial information prepared and presented in accordance with GAAP. This measure may be different from non-GAAP financial measures used by other companies, limiting its usefulness for comparison purposes. We encourage investors to carefully consider our results under GAAP, as well as our supplemental non-GAAP results, to more fully understand our business.
Overview
ServiceNow was founded on a simple premise: a better technology platform will help work flow better. Our purpose is to make the world work better for everyone. We help global enterprises across industries, universities and governments to digitize their workflows. The Now Platform, seamlessly connects workflows across siloed organizations and systems in a way that unlocks productivity, improves experiences for both employees and customers and delivers real business outcomes. We organize our workflow applications along four primary areas: Technology, Customer and Industry, Employee and Creator. The Now Platform enables our customers’ digital transformation from non-integrated enterprise technology solutions with manual and disconnected processes and activities, to integrated enterprise technology solutions with automation and connected processes and activities. The transformation to digital operations, enabled by the Now Platform, increases our customers’ resiliency and security and delivers great experiences and additional value to their employees and consumers.
We are closely monitoring the unfolding events of the Russian invasion of Ukraine and the current armed conflict in Israel and the Gaza Strip. While these events are still evolving and the outcome remains highly uncertain, we do not believe the conflicts will have a material impact on our business and results of operations. However, if the conflicts continue or worsen, leading to greater global economic disruptions and uncertainty, our business and results of operations could be materially impacted. Our customers in these regions represented an immaterial portion of our net assets as of September 30, 2023 and December 31, 2022, and of our total consolidated revenues for each of the three and nine months ended September 30, 2023 and 2022.
Additionally, other recent macroeconomic events, including rising interest rates, global inflation and bank failures, have led to further economic uncertainty in the global economy. To mitigate risk, our cash and cash equivalents are distributed across several large financial institutions and are not concentrated in one financial institution. We have not experienced any impact to our liquidity or to our current and projected business operations and financial condition due to recent bank failures. In addition, we have policy restrictions in place on the types of securities that can be purchased as part of our available-for-sale debt securities portfolio. These restrictions take industry and company concentration limits into consideration among other things. Furthermore, the majority of our non-marketable equity investments do not have material relationships with any one financial institution, and therefore, we believe that our exposure to loss is immaterial. We will continue to monitor the direct and indirect impact of macroeconomic events on our business and financial results.
See the “Risk Factors” section in Part I, Item 1A of our Annual Report on Form 10-K filed with the SEC on January 31, 2023 and in Part II, Item 1A of this Quarterly Report on Form 10-Q for further discussion of the possible impact of the Russia-Ukraine conflict and the macroeconomic conditions on our business.
Key Business Metrics
Remaining performance obligations. Transaction price allocated to remaining performance obligations (“RPO”) represents contracted revenue that has not yet been recognized, which includes deferred revenue and non-cancellable amounts that will be invoiced and recognized as revenue in future periods. RPO excludes contracts that are billed in arrears, such as certain time and materials contracts, as we apply the “right to invoice” practical expedient under relevant accounting guidance. Current remaining performance obligations (“cRPO”) represents RPO that will be recognized as revenue in the next 12 months.
As of September 30, 2023, our RPO was $14.4 billion, of which 52% represented cRPO. RPO and cRPO increased by 26% compared to September 30, 2022. Factors that may cause our RPO to vary from period to period include the following:
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Foreign currency exchange rates. While a majority of our contracts have historically been in U.S. Dollars, an increasing percentage of our contracts in recent periods has been in foreign currencies, particularly the Euro and British Pound Sterling. Fluctuations in foreign currency exchange rates as of the balance sheet date will cause variability in our RPO.
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Mix of offerings. In a minority of cases, we allow our customers to host our software by themselves or through a third-party service provider. In self-hosted offerings, we recognize a portion of the revenue upfront upon the delivery of the software and as a result, such revenue is excluded from RPO.
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Subscription start date. From time to time, we enter into contracts with a subscription start date in the future and these amounts are included in RPO if such contracts are signed by the balance sheet date.
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Timing of contract renewals. While customers typically renew their contracts at the end of the contract term, from time to time, customers may do so either before or after the scheduled expiration date. For example, in cases where we are successful in selling additional products or services to an existing customer, a customer may decide to renew its existing contract early to ensure that all its contracts expire on the same date. In other cases, prolonged negotiations or other factors may result in a contract not being renewed until after it has expired.
*•*Contract duration. While we typically enter into multi-year subscription services, the duration of our contracts varies. Further, we continue to see an increase in the number of 12-month agreements entered into with the U.S. federal government throughout the year, with the highest number of agreements entered into in the quarter ended September 30, driven primarily by timing of their annual budget expenditures. We sometimes also enter into contracts with durations that have a 12-month or shorter term to enable the contracts to co-terminate with the existing contract. The contract duration will cause variability in our RPO.
Number of customers with ACV greater than $1 million. We count the total number of customers with annual contract value (“ACV”) greater than $1 million as of the end of the period. We had 1,789 and 1,535 customers with ACV greater than $1 million as of September 30, 2023 and 2022, respectively. For purposes of customer count, a customer is defined as an entity that has a unique Dunn & Bradstreet Global Ultimate (“GULT”) Data Universal Numbering System (“DUNS”) number and an active subscription contract as of the measurement date. The DUNS number is a global standard for business identification and tracking. We make exceptions for holding companies, government entities and other organizations for which the GULT, in our judgment, does not accurately represent the ServiceNow customer. For example, while all U.S. government agencies roll up to “Government of the United States” under the GULT, we count each government agency that we contract with as a separate customer. Our customer count is subject to adjustments for acquisitions, spin-offs and other market activity; accordingly, we restate previously disclosed number of customers with ACV greater than $1 million calculations to allow for comparability. ACV is calculated based on the foreign exchange rate in effect at the time the contract was signed. Foreign exchange rate fluctuations could cause some variability in the number of customers with ACV greater than $1 million. We believe information regarding the total number of customers with ACV greater than $1 million provides useful information to investors because it is an indicator of our growing customer base and demonstrates the value customers are receiving from the Now Platform.
Free cash flow. We define free cash flow, a non-GAAP financial measure, as GAAP net cash provided by operating activities plus cash paid for legal settlements, repayments of convertible senior notes attributable to debt discount and business combination and other related costs including compensation expense, reduced by purchases of property and equipment. Purchases of property and equipment are included in cash used in investing activities under GAAP. We believe information regarding free cash flow provides useful information to investors because it is an indicator of the strength and performance of our business operations. However, our calculation of free cash flow may not be comparable to similar measures used by other companies. A calculation of free cash flow is provided below:
| Nine Months Ended September 30, | % Change | ||||||||||||||||
| 2023 | 2022 | ||||||||||||||||
| (dollars in millions) | |||||||||||||||||
| Free cash flow: | |||||||||||||||||
| Net cash provided by operating activities | $ | 1,793 | $ | 1,561 | 15 | % | |||||||||||
| Purchases of property and equipment | (433) | (406) | 7 | % | |||||||||||||
| Business combination and other related costs | 24 | 5 | 380 | % | |||||||||||||
| Free cash flow | $ | 1,384 | $ | 1,160 | 19 | % |
We have historically seen higher collections in the quarter ended March 31 due to seasonality in timing of entering into customer contracts, which is significantly higher in the quarter ended December 31. Additionally, we have historically seen higher disbursements in the quarters ended March 31 and September 30 due to payouts under our annual commission plans, purchases under our employee stock purchase plan, payouts under our bonus plans and coupon payments related to our 2030 Notes.
Renewal rate. We calculate our renewal rate by subtracting our attrition rate from 100%. Our attrition rate for a period is equal to the ACV from customers lost during the period, divided by the sum of (i) the total ACV from all customers that renewed during the period, excluding changes in price or users, and (ii) the total ACV from all customers lost during the period. Accordingly, our renewal rate is calculated based on ACV and is not based on the number of customers that have renewed. Further, our renewal rate does not reflect increased or decreased purchases from our customers to the extent such customers are not lost customers or lapsed renewals. A lost customer is a customer that did not renew an expiring contract and that, in our judgment, will not be renewed. Typically, a customer that reduces its subscription upon renewal is not considered a lost customer. However, in instances where the subscription decrease represents the majority of the customer’s ACV, we may deem the renewal as a lost customer. For our renewal rate calculation, we define a customer as an entity with a separate production instance of our service and an active subscription contract as of the measurement date, instead of an entity with a unique GULT or DUNS number. We adjust our renewal rate for acquisitions, consolidations and other customer events that cause the merging of two or more accounts occurring at the time of renewal. Our renewal rate was 98% for each of the three and nine months ended September 30, 2023 and 2022. As our renewal rate is impacted by the timing of renewals, which could occur in advance of, or subsequent to the original contract end date, period-to-period comparison of renewal rates may not be meaningful.
Components of Results of Operations
Revenues
Subscription revenues. Subscription revenues are primarily comprised of fees that give customers access to the ordered subscription service for both self-hosted offerings and cloud-based subscription offerings, and related standard and enhanced support and updates, if any, to the subscription service during the subscription term. For our cloud-based offerings, we recognize revenue ratably over the subscription term. For self-hosted offerings, a substantial portion of the sales price is recognized upon delivery of the software, which may cause greater variability in our subscription revenues and subscription gross margin. Pricing includes multiple instances, hosting and support services, data backup and disaster recovery services, as well as future updates, when and if available, offered during the subscription term. We typically invoice our customers for subscription fees in annual increments upon execution of the initial contract or subsequent renewal. Our contracts are generally non-cancellable during the subscription term, though a customer can terminate for breach if we materially fail to perform.
Professional services and other revenues. Our arrangements for professional services are primarily on a time-and-materials basis, and we generally invoice our customers monthly in arrears for the professional services based on actual hours and expenses incurred. Some of our professional services arrangements are on a fixed fee basis. Professional services revenues are recognized as services are delivered. Other revenues primarily consist of fees from customer training delivered on-site or through publicly available classes. Typical payment terms require our customers to pay us within 30 days of invoice.
We sell our subscription services primarily through our direct sales organization. We also sell services through managed service providers and resale partners. We also generate revenues from certain professional services and from training of customers and partner personnel, through both our direct team and indirect channel sales. Revenues from our direct sales organization represented 79% of our total revenues for each of the three and nine months ended September 30, 2023 and 2022. For purposes of calculating revenues from our direct sales organization, revenues from systems integrators and managed services providers are included as part of the direct sales organization.
Seasonality. We have historically experienced seasonality in terms of when we enter into customer agreements. We sign a significantly higher percentage of agreements with new customers, as well as expansion with existing customers, in the fourth quarter of each year. The increase in customer agreements for the fourth quarter is primarily a result of both large enterprise account buying patterns typical in the software industry, which are driven primarily by the expiration of annual authorized budgeted expenditures, and the terms of our commission plans, which incentivize our direct sales organization to meet their annual quotas by December 31. Furthermore, we usually sign a significant portion of these agreements during the last month, and often the last two weeks, of each quarter. This seasonality of entering into customer agreements is sometimes not immediately apparent in our revenues, due to the fact that we recognize subscription revenues from our cloud offering contracts over the term of the subscription agreement, which is generally 12 to 36 months, leading to a higher RPO in the fourth quarter. Although these seasonal factors are common in the technology industry, historical patterns should not be considered a reliable indicator of our future sales activity or performance.
Cost of Revenues
Cost of subscription revenues. Cost of subscription revenues consists primarily of expenses related to hosting our services and providing support to our customers. These expenses are comprised of data center capacity costs, which include colocation costs associated with our data centers as well as interconnectivity between data centers, depreciation related to our infrastructure hardware equipment dedicated for customer use, amortization of intangible assets, expenses associated with software, public cloud service costs, IT services and dedicated customer support, personnel-related costs directly associated with data center operations and customer support, including salaries, benefits, bonuses and stock-based compensation and allocated overhead.
Cost of professional services and other revenues. Cost of professional services and other revenues consists primarily of personnel-related costs directly associated with our professional services and training departments, including salaries, benefits, bonuses and stock-based compensation, the costs of contracted third-party partners, travel expenses and allocated overhead.
Professional services are performed directly by our services team, as well as by contracted third-party partners. Fees paid by us to third-party partners are primarily recognized as cost of revenues as the professional services are delivered. Cost of revenues associated with our professional services engagements contracted with third-party partners as a percentage of professional services and other revenues was 10% for each of the three and nine months ended September 30, 2023 and 14% and 13% for each of the three and nine months ended September 30, 2022, respectively.
Sales and Marketing
Sales and marketing expenses consist primarily of personnel-related expenses directly associated with our sales and marketing staff, including salaries, benefits, bonuses and stock-based compensation. Sales and marketing expenses also include the amortization of commissions paid to our sales employees, including related payroll taxes and fringe benefits. In addition, sales and marketing expenses include branding expenses, marketing program expenses, which include events such as Knowledge, costs associated with purchasing advertising and marketing data, software and subscription services dedicated for sales and marketing use and allocated overhead.
Research and Development
Research and development (“R&D”) expenses consist primarily of personnel-related expenses directly associated with our research and development staff, including salaries, benefits, bonuses, stock-based compensation and allocated overhead. Research and development expenses also include data center capacity costs, costs associated with outside services contracted for research and development purposes and depreciation of infrastructure hardware equipment that is used solely for research and development purposes.
General and Administrative
General and administrative (“G&A”) expenses consist primarily of personnel-related expenses for our executive, finance, legal, human resources, facilities and administrative personnel, including salaries, benefits, bonuses, stock-based compensation, external legal, accounting and other professional services fees, other corporate expenses, amortization of intangible assets and allocated overhead.
Provision for (Benefit from) Income Taxes
Provision for (benefit from) income taxes consists of federal, state and foreign income taxes. Our income tax benefit for the nine months ended September 30, 2023 is primarily attributable to the release of the valuation allowance against certain U.S. federal and state deferred tax assets, excluding California. We continue to maintain a valuation allowance against our California deferred tax assets due to the uncertainty regarding realizability of these deferred tax assets as they have not met the “more likely than not” realization criteria, particularly as we expect R&D tax credit generation to exceed our ability to use the credits in future years.
Comparison of the Three and Nine Months Ended September 30, 2023 and 2022
Revenues
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Revenues: | |||||||||||||||||||||||||||||||||||
| Subscription | $ | 2,216 | $ | 1,742 | 27% | $ | 6,315 | $ | 5,031 | 26% | |||||||||||||||||||||||||
| Professional services and other | 72 | 89 | (19%) | 219 | 274 | (20%) | |||||||||||||||||||||||||||||
| Total revenues | $ | 2,288 | $ | 1,831 | 25% | $ | 6,534 | $ | 5,305 | 23% | |||||||||||||||||||||||||
| Percentage of revenues: | |||||||||||||||||||||||||||||||||||
| Subscription | 97% | 95% | 97% | 95% | |||||||||||||||||||||||||||||||
| Professional services and other | 3% | 5% | 3% | 5% | |||||||||||||||||||||||||||||||
| Total | 100% | 100% | 100% | 100% |
Subscription revenues increased by $474 million and $1,284 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily driven by increased purchases by new and existing customers. Included in subscription revenues is $67 million and $53 million of revenues recognized upfront from the delivery of software associated with self-hosted offerings during the three months ended September 30, 2023 and 2022, respectively, and $210 million and $179 million during the nine months ended September 30, 2023 and 2022, respectively.
We expect subscription revenues for the year ending December 31, 2023 to increase in absolute dollars and increase slightly as a percentage of revenue as we continue to add new customers and existing customers increase their usage of our products compared to the year ended December 31, 2022.
Our expectations for revenues, cost of revenues and operating expenses for the remainder of 2023 are based on the 30-day average of foreign exchange rates for September 30, 2023.
Subscription revenues consist of the following:
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Digital workflow products | $ | 1,961 | $ | 1,534 | 28% | $ | 5,587 | $ | 4,437 | 26% | |||||||||||||||||||||||||
| ITOM products | 255 | 208 | 23% | 728 | 594 | 23% | |||||||||||||||||||||||||||||
| Total subscription revenues | $ | 2,216 | $ | 1,742 | 27% | $ | 6,315 | $ | 5,031 | 26% |
Our digital workflow products are generally priced on a per user basis and include the Now Platform, IT Service Management, Strategic Portfolio Management (formerly known as IT Business Management), IT Asset Management and Enterprise Asset Management, Security Operations, Integrated Risk Management (formerly known as Governance, Risk and Compliance), ESG Management, HR Service Delivery, Workplace Service Delivery, Legal Service Delivery, Customer Service Management, Field Service Management, Industry Solutions, App Engine, Automation Engine, Platform Privacy and Security, Source-to-Pay Operations (formerly known as Procurement Operations Management), Supplier Lifecycle Operations, Accounts Payable Operations and Impact. Our IT Operations Management (“ITOM”) products are generally priced on a subscription unit basis, which allows us to measure customers’ management of various IT resources, and decreasingly on a per node (physical or virtual server) basis.
Professional services and other revenues decreased by $17 million and $55 million during the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, due to a decrease in services and trainings provided to new and existing customers.
We expect professional services and other revenues for the year ending December 31, 2023 to decrease in absolute dollars and to decrease slightly as a percentage of revenue compared to the year ended December 31, 2022. We continue to be focused on deploying our internal professional services organization as a strategic resource and working with our partner ecosystem to contract directly with customers for implementation services delivery.
Cost of Revenues and Gross Profit Percentage
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Cost of revenues: | |||||||||||||||||||||||||||||||||||
| Subscription | $ | 420 | $ | 301 | 40% | $ | 1,163 | $ | 863 | 35% | |||||||||||||||||||||||||
| Professional services and other | 76 | 99 | (23%) | 242 | 295 | (18%) | |||||||||||||||||||||||||||||
| Total cost of revenues | $ | 496 | $ | 400 | 24% | $ | 1,405 | $ | 1,158 | 21% | |||||||||||||||||||||||||
| Gross profit (loss) percentage: | |||||||||||||||||||||||||||||||||||
| Subscription | 81% | 83% | 82% | 83% | |||||||||||||||||||||||||||||||
| Professional services and other | (6%) | (11%) | (11%) | (8%) | |||||||||||||||||||||||||||||||
| Total gross profit percentage | 78% | 78% | 79% | 78% | |||||||||||||||||||||||||||||||
| Gross profit | $ | 1,792 | $ | 1,431 | $ | 5,129 | $ | 4,147 | |||||||||||||||||||||||||||
Cost of subscription revenues increased by $119 million and $300 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily due to increased headcount and increased costs to support the growth of our subscription offerings including costs to support customers in regulated markets. Personnel-related costs including stock-based compensation and overhead expenses increased by $59 million and $164 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022. Depreciation expense related to infrastructure hardware equipment dedicated for customer use increased by $29 million and $74 million and maintenance costs to support the expansion of our data center capacity, including public cloud service costs, increased by $27 million and $49 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022.
We expect our cost of subscription revenues for the year ending December 31, 2023 to increase in absolute dollars as we provide subscription services to more customers and increase usage within our customer instances and to increase slightly as a percentage of revenue compared to the year ended December 31, 2022. We will continue to incur incremental costs to attract customers in regulated markets by adopting public cloud offerings as well as increased support for customers impacted by new and evolving data residency requirements. To the extent future acquisitions are consummated, our cost of subscription revenues may increase due to additional non-cash charges associated with the amortization of intangible assets acquired. Our subscription gross profit percentage was 81% and 82% for the three and nine months ended September 30, 2023, respectively, and 83% for each of the three and nine months ended September 30, 2022. We expect our subscription gross profit percentage to decrease slightly for the year ending December 31, 2023 compared to the year ended December 31, 2022.
Cost of professional services and other revenues decreased by $23 million and $53 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily due to a decrease in contracted third-party partners spend and decreased headcount resulting in a decrease in personnel-related costs, including stock-based compensation.
Our professional services and other gross loss percentage improved to 6% for the three months ended September 30, 2023 compared to 11% for the three months ended September 30, 2022, primarily due to a decrease in contracted third-party partners spend and decreased headcount resulting in a decrease in personnel-related costs. Professional services and other gross loss percentage increased to 11% for the nine months ended September 30, 2023 compared to 8% for the nine months ended September 30, 2022, primarily driven by professional services and other revenue declining at a faster rate than personnel-related costs and contracted third-party partners spend. We expect our professional services and other gross loss percentage to remain relatively flat for the year ending December 31, 2023 compared to the year ended December 31, 2022.
Sales and Marketing
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Sales and marketing | $ | 799 | $ | 697 | 15% | $ | 2,454 | $ | 2,092 | 17% | |||||||||||||||||||||||||
| Percentage of revenues | 35% | 38% | 38% | 39% | |||||||||||||||||||||||||||||||
Sales and marketing expenses increased by $102 million and $362 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily due to increased headcount resulting in an increase in personnel-related costs including stock-based compensation and overhead expenses of $79 million and $261 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022. Amortization expenses associated with deferred commissions increased by $20 million and $70 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, due to an increase in contracts with new customers, expansion and renewal contracts. Other sales and marketing program expenses, which includes branding, costs associated with purchasing advertising, marketing events and market data, increased by $29 million for the nine months ended September 30, 2023 compared to the same period of the prior year, primarily due to increased program costs and travel for our annual Sales Kickoff.
We expect sales and marketing expenses for the year ending December 31, 2023 to increase in absolute dollars and to decrease slightly as a percentage of revenue compared to the year ended December 31, 2022, as we continue to see leverage from increased sales productivity and marketing efficiencies offset by growth in our international operations in 2023.
Research and Development
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Research and development | $ | 549 | $ | 456 | 20% | $ | 1,562 | $ | 1,314 | 19% | |||||||||||||||||||||||||
| Percentage of revenues | 24% | 25% | 24% | 25% | |||||||||||||||||||||||||||||||
R&D expenses increased by $93 million and $248 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily due to increased headcount, resulting in an increase in personnel-related costs including stock-based compensation and overhead expenses of $77 million and $225 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022. The remaining increase was primarily due to an increase in data center capacity costs and depreciation of infrastructure hardware equipment that is used solely for R&D purposes of $8 million and $15 million for the three and nine months ended September 30, 2023, respectively, compared to the same periods in the prior year.
We expect R&D expenses for the year ending December 31, 2023 to increase in absolute dollars but remain relatively flat as a percentage of revenue compared to the year ended December 31, 2022, as we continue to improve the existing functionality of our services, develop new applications to fill market needs and enhance our core platform.
General and Administrative
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| General and administrative | $ | 213 | $ | 187 | 14% | $ | 621 | $ | 541 | 15% | |||||||||||||||||||||||||
| Percentage of revenues | 9% | 10% | 10% | 10% | |||||||||||||||||||||||||||||||
G&A expenses increased by $26 million and $80 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily due to increased headcount, resulting in an increase in personnel-related costs including stock-based compensation and overhead expenses of $21 million and $61 million for the three and nine months ended September 30, 2023, respectively, compared to the same periods in the prior year. Non personnel-related costs and outside services increased by $15 million for the nine months ended September 30, 2023 compared to the same period in the prior year.
We expect G&A expenses for the year ending December 31, 2023 to increase in absolute dollars but remain relatively flat as a percentage of revenue compared to the year ended December 31, 2022, as we continue to see leverage from continued G&A productivity.
Stock-based Compensation
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Cost of revenues: | |||||||||||||||||||||||||||||||||||
| Subscription | $ | 52 | $ | 41 | 27 | % | $ | 148 | $ | 116 | 28 | % | |||||||||||||||||||||||
| Professional services and other | 11 | 17 | (35 | %) | 40 | 51 | (22 | %) | |||||||||||||||||||||||||||
| Operating expenses: | |||||||||||||||||||||||||||||||||||
| Sales and marketing | 132 | 119 | 11 | % | 378 | 337 | 12 | % | |||||||||||||||||||||||||||
| Research and development | 150 | 127 | 18 | % | 430 | 368 | 17 | % | |||||||||||||||||||||||||||
| General and administrative | 68 | 57 | 19 | % | 195 | 166 | 17 | % | |||||||||||||||||||||||||||
| Total stock-based compensation | $ | 413 | $ | 361 | 14 | % | $ | 1,191 | $ | 1,038 | 15 | % | |||||||||||||||||||||||
| Percentage of revenues | 18% | 20% | 18% | 20% |
Stock-based compensation increased by $52 million and $153 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily due to additional grants to current and new employees.
Stock-based compensation is inherently difficult to forecast due to fluctuations in our stock price. Based upon our stock price as of September 30, 2023, we expect stock-based compensation to continue to increase in absolute dollars for the year ending December 31, 2023 as we continue to issue stock-based awards to our employees, but decrease slightly as a percentage of revenue compared to the year ended December 31, 2022. We expect stock-based compensation as a percentage of revenue to decline over time as we continue to grow.
Foreign Currency Exchange
Our international operations have provided and will continue to provide a significant portion of our total revenues. Revenues outside North America represented 37% and 36% of total revenues for each of the three and nine months ended September 30, 2023, respectively, and 34% and 35% for each of the three and nine months ended September 30, 2022, respectively.
We primarily transact in certain foreign currencies for sales outside of the United States. The general weakening of the U.S. Dollar relative to certain major foreign currencies (primarily the Euro and British Pound Sterling) had a favorable impact on our revenues for the three months ended September 30, 2023. For entities reporting in currencies other than the U.S. Dollar, if we had translated our results for the three months ended September 30, 2023 at the exchange rates in effect for the three months ended September 30, 2022 rather than the actual exchange rates in effect during the period, our reported subscription revenues would have been $43 million lower. The impact from foreign currency movements from the nine months ended September 30, 2022 to the nine months ended September 30, 2023 was not material for subscription revenues. The impact from the foreign currency movements from the three and nine months ended September 30, 2022 to the three and nine months ended September 30, 2023 was not material for professional services and other revenues.
In addition, because we primarily transact in several foreign currencies for cost of revenues and operating expenses outside of the United States, the general strengthening of the U.S. Dollar relative to these major foreign currencies had a favorable impact on our sales and marketing and R&D expenses for the nine months ended September 30, 2023. For entities reporting in currencies other than the U.S. Dollar, if we had translated our results for the nine months ended September 30, 2023 at the exchange rates in effect for the nine months ended September 30, 2022 rather than the actual exchange rates in effect during the period, our reported sales and marketing and R&D expenses would have been $10 million and $11 million higher, respectively, for the nine months ended September 30, 2023. The impact from the foreign currency movements from the three months ended September 30, 2022 to the three months ended September 30, 2023 was not material to cost of revenues, sales and marketing, R&D and G&A expenses. The impact from the foreign currency movements from the nine months ended September 30, 2022 to the nine months ended September 30, 2023 was not material to cost of revenues and G&A expenses.
Interest Income
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Interest income | $ | 82 | $ | 26 | 215% | $ | 216 | $ | 43 | NM | |||||||||||||||||||||||||
| Percentage of revenues | 4 | % | 1% | 3 | % | 1% |
NM - Not meaningful
Interest income increased by $56 million and $173 million for the three and nine months ended September 30, 2023, respectively, compared to the three and nine months ended September 30, 2022, primarily driven by an increase in investment income from our managed portfolio resulting from higher portfolio balances and an increase in interest rates.
Other Expense, net
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Interest expense | $ | (6) | $ | (8) | (25%) | $ | (18) | $ | (20) | (10%) | |||||||||||||||||||||||||
| Other | (8) | (7) | 14% | (29) | (7) | 314% | |||||||||||||||||||||||||||||
| Other expense, net | $ | (14) | $ | (15) | (7%) | $ | (47) | $ | (27) | 74% | |||||||||||||||||||||||||
| Percentage of revenues | (1%) | (1%) | (1%) | (1)% |
Other expense, net decreased by $1 million for the three months ended September 30, 2023 and increased by $20 million for the nine months ended September 30, 2023 compared to the same periods in the prior year. The increase in other expense, net for the nine months ended September 30, 2023 was primarily driven by higher foreign exchange loss, unrealized loss on marketable equity securities and impairment of non-marketable equity investments.
To mitigate our risks associated with fluctuations in foreign currency exchange rates, we enter into foreign currency forward contracts with maturities of 12 months or less to hedge a portion of our net outstanding monetary assets and liabilities. These hedging contracts may reduce, but cannot entirely eliminate, the impact of adverse currency exchange rate movements. The gains (losses) recognized for these foreign currency forward contracts in other expense, net were immaterial for each of the three and nine months ended September 30, 2023 and 2022.
Provision for (benefit from) Income Taxes
| Three Months Ended September 30, | % Change | Nine Months Ended September 30, | % Change | ||||||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | ||||||||||||||||||||||||||||||||
| (dollars in millions) | (dollars in millions) | ||||||||||||||||||||||||||||||||||
| Income before income taxes | $ | 299 | $ | 102 | 193% | $ | 661 | $ | 216 | 206% | |||||||||||||||||||||||||
| Provision for (benefit from) income taxes | $ | 57 | $ | 22 | 159% | $ | (775) | $ | 41 | NM | |||||||||||||||||||||||||
| Effective tax rate | 19% | 22% | (117%) | 19% |
NM - Not meaningful
The income tax provision was $57 million for the three months ended September 30, 2023, and our income tax benefit was $775 million for the nine months ended September 30, 2023. The income tax provision was primarily attributable to the mix of earnings and losses in countries with differing statutory tax rates, tax deductible R&D costs and the valuation allowance release through the effective tax rate. The income tax benefit was primarily attributable to the release of the valuation allowance of certain U.S. federal and state deferred tax assets. We regularly assess the need for a valuation allowance against our deferred tax assets. In making that assessment, we consider both positive and negative evidence related to the likelihood of realization of the deferred tax assets to determine, based on the weight of available evidence, whether it is more likely than not that some or all of the deferred tax assets will not be realized. As of June 30, 2023, we achieved cumulative U.S. income during the prior twelve quarters when considering pre-tax income adjusted for permanent differences and other comprehensive losses. Based on all available positive and negative evidence, having demonstrated sustained profitability which is objective and verifiable, and taking into account anticipated future earnings, we concluded it is more likely than not that our U.S. federal and state deferred tax assets will be realizable, with the exception of California. We continue to maintain a valuation allowance against our California deferred tax assets due to the uncertainty regarding realizability of these deferred tax assets as they have not met the “more likely than not” realization criteria, particularly as we expect R&D tax credit generation to exceed our ability to use the credits in future years. When a change in valuation allowance is recognized during an interim period, the change in valuation allowance resulting from current year income is included in the annual effective tax rate and the release of valuation allowance supported by projections of future taxable income is recorded as a discrete tax benefit in the interim period. Of the $1.2 billion valuation allowance as of December 31, 2022, we released $843 million as a discrete tax benefit and $142 million as part of the effective tax rate during the nine months ended September 30, 2023. $65 million of the valuation allowance will be released during the fourth quarter of 2023, and we will continue to maintain a valuation allowance of $177 million against our California deferred tax assets. We will continue to monitor the need for a valuation allowance against our deferred tax assets on a quarterly basis.
Our income tax provision was $22 million and $41 million for the three and nine months ended September 30, 2022, respectively. The income tax provision was primarily attributable to the mix of earnings and losses in countries with differing statutory tax rates and the valuation allowance in the United States.
Liquidity and Capital Resources
We generate cash inflows from operations primarily from selling subscription services which are generally paid in advance of provisioning services, and cash outflows to develop new services and core technologies that further enhance the Now Platform, engage our customer and enhance their experience, and enable and transform our business operations. Subscription services arrangements typically have a three-year duration, and we have experienced a renewal rate of 98% over the last three years. Cash outflows from operations are principally comprised of the salaries, bonuses, commissions and benefits for our workforce; licenses and services arrangements that are integral to our business operations and data centers; and operating lease arrangements that underlie our facilities. We have generated positive operating cash flows for more than ten years as we continue to grow our business in pursuit of our business strategy, and we expect to grow our business and generate positive cash flows from operations during 2023. When assessing sources of liquidity, we also include cash and cash equivalents, short-term investments and long-term investments totaling $7 billion as of September 30, 2023.
Our working capital requirements are principally comprised of non-contract workforce salaries, bonuses, commissions and benefits and, to a lesser extent, cancellable and non-cancellable licenses and services arrangements that are integral to our business operations and operating lease obligations. Operating lease obligations totaling $919 million are principally associated with leased facilities and have varying maturities with $487 million due over the next five years.
We may repurchase our shares of common stock in the open market, in privately negotiated transactions or by other means, with the objective to return value to our stockholders and manage the dilution from future employee equity grants and employee stock purchase programs. In May 2023, our board of directors authorized a program to repurchase up to $1.5 billion of our common stock. During the quarter ended September 30, 2023, the Company repurchased 0.5 million shares of its common stock for $282 million. All repurchases were made in open market transactions. Repurchases of common stock are recognized as treasury stock and held for future issuance. As of September 30, 2023, approximately $1.2 billion of the originally authorized amount under the Share Repurchase Program remained available for future repurchases.
To grow our business, we also invest in capital and other resources to expand our data centers and enable our workforce, and we acquire technology and businesses to supplement our technology portfolio. Our capital expenditures are typically under cancellable arrangements primarily used to support the installed base and growth of our hosted business. We have also issued long-term debt to finance our business. In August 2020, we issued 1.40% fixed rate ten-year notes with an aggregate principal amount of $1.5 billion due on September 1, 2030 (the “2030 Notes”).
Our free cash flows, together with our other sources of liquidity, are available to service our liabilities as well as our cancellable and non-cancellable arrangements. We anticipate cash flows generated from operations, cash, cash equivalents and investments will be sufficient to meet our liquidity needs for at least the next 12 months. As we look beyond the next 12 months, we seek to continue to grow free cash flows necessary to fund our operations and grow our business. If we require additional capital resources, we may seek to finance our operations from the current funds available or additional equity or debt financing.
| Nine Months Ended September 30, | |||||||||||
| 2023 | 2022 | ||||||||||
| (dollars in millions) | |||||||||||
| Net cash provided by operating activities | $ | 1,793 | $ | 1,561 | |||||||
| Net cash used in investing activities | $ | (1,723) | $ | (1,709) | |||||||
| Net cash used in financing activities | $ | (422) | $ | (269) | |||||||
| Net decrease in cash, cash equivalents and restricted cash | $ | (356) | $ | (478) |
Operating Activities
Net cash provided by operating activities was $1,793 million for the nine months ended September 30, 2023 compared to $1,561 million for the nine months ended September 30, 2022. The net increase in operating cash flows was primarily due to higher collections driven by revenue growth.
Investing Activities
Net cash used in investing activities for the nine months ended September 30, 2023 was $1,723 million compared to $1,709 million for the nine months ended September 30, 2022. The net increase in cash used in investing activities was primarily due to a $225 million increase in business combinations, a $27 million increase in purchases of property and equipment, partially offset by a $174 million decrease in net purchases of investments and a $82 million decrease in purchases of non-marketable investments.
Financing Activities
Net cash used in financing activities was $422 million for the nine months ended September 30, 2023 compared to net cash used in financing activities of $269 million for the nine months ended September 30, 2022. The increase in cash used in financing activities was due to repurchases of common stock of $282 million, partially offset by a $94 million decrease related to repayments of convertible senior notes attributable to principal, a $19 million decrease in taxes paid related to net share settlement of equity awards and a $16 million increase in proceeds from employee stock plans.
Critical Accounting Policies and Significant Judgments and Estimates
There have been no significant changes to our critical accounting policies and estimates as described in our Annual Report on Form 10-K for the year ended December 31, 2022, which was filed with the SEC on January 31, 2023.
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