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ServiceNow, Inc. (NOW) Q4 2021 Earnings Call Transcript

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ServiceNow, Inc. (NYSE: NOW) Q4 2021 earnings call dated Jan. 26, 2022

Corporate Participants:

Darren Yip — Vice President, Investor Relations

Bill McDermott — President and Chief Executive Officer

Gina Mastantuono — Chief Financial Officer

Analysts:

Phil Winslow — Credit Suisse — Analyst

Raimo Lenschow — Barclays — Analyst

Alex Zukin — Wolfe Research — Analyst

Kash Rangan — Goldman Sachs — Analyst

Keith Weiss — Morgan Stanley — Analyst

Michael Turits — KeyBanc — Analyst

Brad Zelnick — Deutsche Bank — Analyst

Pat Walravens — JMP Securities — Analyst

Drew Glaeser — JPMorgan — Analyst

Presentation:

Operator

Ladies and gentlemen, thank you for standing by and welcome to ServiceNow’s Fourth Quarter Fiscal 2021 Earnings Call. [Operator Instructions] After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]

Darren Yip, Vice President of Investor Relations, you may begin your conference.

Darren Yip — Vice President, Investor Relations

Good afternoon and thank you for joining ServiceNow’s fourth quarter and full-year 2021 earnings conference call. Joining me are Bill McDermott, our President and Chief Executive Officer; and Gina Mastantuono, our Chief Financial Officer. During today’s call, we will review our fourth quarter 2021 results and discuss our guidance for the first quarter and full-year 2022.

Before we get started, we want to emphasize that some of our information discussed on this call, such as guidance is based on information as of today and contains forward-looking statements that involve risks, uncertainties, and assumptions, including those related to the impact of COVID-19 on our business and global economic conditions. We undertake no duty or obligation to update such statements as a result of new information or future events. Please refer to today’s earnings press release and our SEC filings, including our most recent 10-Q and our 2021 10-K that will be filed for factors that may cause actual results to differ materially from those set forth in such forward-looking statements.

We’d like to also point out that we have presented non-GAAP measures in addition to and not as a substitute for financial measures calculated in accordance with GAAP. Unless otherwise noted, all financial measures and related growth rates we discussed today are non-GAAP except for revenues, remaining performance obligations or RPO and current RPO. To see the reconciliation between these non-GAAP and GAAP measures, please refer to today’s earnings press release and investor presentation, which are both posted on our website at investors.servicenow.com. A replay of today’s call will also be posted on our website.

With that, I would now like to turn the call over to Bill.

Bill McDermott — President and Chief Executive Officer

Thank you very much, Darren, and a warm welcome to everybody joining us on today’s call. ServiceNow has once again delivered results that significantly beat the high end of expectations. Here is the Q4 run down in constant currency. Subscription revenue growth was 30%, cRPO growth was 32%, free cash flow growth was 32%, adjusted subscription billings growth was an exceptional 33%, operating margin was 23%, one point over our guidance.

We had a record 135 deals over $1 million, which was up 50% year-over-year. There is long been a Rule of 40 benchmark for highly successful software companies. These results demonstrate that ServiceNow operates beyond the Rule of 60. The company is expanding in all geographies, industries and by our personas. Gina will share the details in a few moments including our strong 2022 guidance.

ServiceNow is uniquely positioned. We’re growing like a fast-moving startup with the profitability of a global market leader. We’re on a clear growth trajectory to $15 billion plus by 2026. While our strong cash position preserves optionality, we don’t depend on M&A for growth. While rising interest rates challenge others, ServiceNow’s business model is built to flourish in any economic environment. We are not opportunity-constrained. As our customers need for digital transformation is ever expanding, our organic growth machine is in full-flight and our pipeline is stronger than ever. Our 99% renewal rate is one of several lead indicators for sustained performance moving forward. I’d like to thank all of our stakeholders, especially our customers for their steadfast confidence in ServiceNow.

I’ll give you the breakdown of our portfolio results, but first, let’s discuss the market dynamics. We’re in a sustained demand environment here. There are structural challenges facing every industry in every geographic region with great resignation, supply chain disruption, inflation to name a few. These underscore point we have made consistently. The technology strategy has become the business strategy.

Digital technologies are growth stimulating deflationary force. They power new business models, accelerating productivity while reducing costs. 85% of Chief Executives will sustain or increase technology budgets this year and that’s according to IDC’s Global CEO survey. IDC has increased their forecast for digital transformation now a $10.7 trillion opportunity through 2025. Gartner forecast worldwide software spending will increase 12% in 2022. The data shows this is clearly more than a pandemic induced transformation. A CEO I spoke to last week said it perfectly, “I have a long list of strategic priorities. Technology is one of them, it runs through all of them.”

ServiceNow’s Q4 results clearly validate the structural incline of this digital economy. As enterprises build, deploy and monitor and service technology, our IT workflow business is at the core. IT service management was in 16 of our top 20, Q4 deals with 19 deals over $1 million. IT operations management was in 18 of our top 20 with 21 deals over $1 million.

Bell Canada, Canada’s largest telco company uses IT workflows and IT operations management to enable its operations. Our platform will improve critical dimensions of both asset management and the employee experience. ServiceNow will also be supporting the United States space force to connect its space operators with war fighters across the globe.

The hyperfocus on hybrid work continues to propel our employee workflows business. HR service delivery was in 11 of our top 20 deals with an exciting 24 deals over $1 million. Johnson Controls International, a smart building solutions leader, will use employee workflows to unlock productivity for its 105,000 employees. Together with ServiceNow they’re focused on creating a human centered approach to the employee experience. Nvidia is using employee workflows to support its employee experience transformation. With ServiceNow Nvidia will provide its global employees a unified service model to support its mission by providing a frictionless employee experience.

CVS Health will also leverage our technology and employee workflows to help deliver a best-in-class colleague experience. As business integration is key to customer service, our customer workflows business is thriving. Customer Service management was in 13 of our top 20 deals with 10 deals over $1 million. Google Cloud plans to use our customer workflows to enhance its customer support operations.

British Telecom chose ServiceNow to address the needs of its next generation of customers and ServiceNow platform will help BT accelerate the delivery of new services from 36 weeks to three. Our new industry vertical solutions also continued to gain traction with wins at major brands, including SAS Institute, Deutsche Telekom, and Wellstar. Technology teams alone can’t build the 500 million new applications IDC forecast by 2023. Our Creator Workflows business is leading the citizen developer revolution.

Our Platform Solutions were in 19 of our top 20 deals. Lockheed Martin, the world’s largest aerospace and defense company, is using ServiceNow to support its enterprise digital transformation. They will use our Creator Workflows to help automate processes globally. Petrobras, a Brazilian energy company is using Creator Workflows as the foundation for its application development function. They have already built over 26 applications such as on-boarding for oil platforms and managing data privacy regulations.

Together, these businesses, IT, customer, employee, creator represent a next generation suites built on a pure play born in the cloud architecture. Our intuitive consumer grade experience is expanding adoption of this platform everywhere, already 70 million uses strong. This has created a unique mode in terms of ServiceNow’s strategic relevance in the enterprise. From a geographic perspective, we continue to see momentum worldwide. This includes APJ with wins at Samsung SDS in South Korea and NEC in Japan. In EMEA, we’re partnering with the French postal service La Poste and leading Italian energy company, Enel.

As you can see, the digital opportunity is expanding dramatically for ServiceNow. Already in 2022, we’re taking significant steps on our long-term roadmap. We’re introducing a state-of-the-art new solution ServiceNow Impact. Leaders need a command center to navigate the fully connected world. ServiceNow Impact includes an intuitive consumer grade mobile application that visualizes the value from transformation investments in real-time on their device. As this experience speeds up user adoption, we anticipate a significant halo effect with broader consumption of our growing solutions portfolio.

As our market opportunities expand, we are promoting strong leaders for scale. As a result of the consistent speed and unmatched quality of our innovation teams, we are expanding CJ Desai’s role to Chief Operating Officer of the company. He will continue to lead products and engineering while also assuming industry and solution responsibilities for the company.

Our top Sales Leader, Kevin Haverty, has executed at an [Indecipherable] form level for more than 10-years at ServiceNow. Kevin will also step into a strategic role for the company serving as a mentor for the next generation of ServiceNow leaders. He will work directly with me on expanding our footprint in the public sector worldwide. Paul Smith will become Chief Commercial Officer assuming our global sales responsibility. As ServiceNow’s President of Europe, Middle East, and Africa, Paul has established himself as a leader of consequence, who can broaden the geographic reach of ServiceNow. All regions in the company have outstanding leadership in place and I’m very, very proud of the work they are doing indeed.

We’re also recruiting outstanding new leaders to the company. Karen Pavlin has joined ServiceNow to become Chief Diversity Equity and Inclusion Officer. Karen joins from our great partner Accenture where she led this function. She will help us embed diverse strategies directly into our business strategy, because inclusive companies outperform all the others. While our leadership team continues to strengthen, our inspired global workforce remains ever loyal.

Look at our retention rate. ServiceNow is not only recruiting great talent, we keep it. In the engineering function as an example, we see much lower attrition rates than any of our peer group benchmarks. While no company is immune from the war on talent, our unique culture puts us in a highly differentiated position. Our high rankings from Glassdoor show that our people are invested in ServiceNow’s bright future. We see growth everywhere for ServiceNow.

Our customers now view us as the standard platform for digital transformation. Our engineers continue to strengthen this highly innovative scalable platform architecture. Our customer success teams have navigated the COVID challenges without missing a beat. Our partner ecosystem continues to build ServiceNow practices with even bigger commitments for long-term growth. The market forces are moving even more intensely in our direction.

For the future work, businesses need to integrate disparate systems. Leaders are more invested in ESG than ever. There are two common threads here. First, ServiceNow’s platform is purpose built for each opportunity. Our new integrated ESG in a box offering is a perfect example. Second, every company wants to become an exponential business. They cannot do that with linear processes. Of the 20 most valuable companies 30-years ago, zero are in the top 20 today. The question is then which companies will be on that list 10-years from now? To be in that conversation, leaders need outcomes really fast. ServiceNow gives them the speed, advantage they are look for. We are empowering digital first leaders to accelerate their vision.

Our purpose is to make the world work better for everyone. Our ambition is to be the defining enterprise software company of the 21st century. ServiceNow’s 2021 results and strong 2022 guidance signal our unshakable confidence in that goal. Our performance should leave no doubt we are executing on all cylinders and we will continue to do so. The world is looking for market leaders to build a new inclusive sustainable wave of economic value and ServiceNow is delivering. This is why we embrace the brand, the model and the maxim, the world works with ServiceNow.

Thank you for your time. I look forward to your questions. Now over to our great CFO, Gina Mastantuono. Gina, over to you.

Gina Mastantuono — Chief Financial Officer

Thank you, Bill, and Happy New Year to everyone listening in. Q4 was a fantastic quarter capping an already phenomenal 2021. Despite increased FX headwinds, ServiceNow outperformed across all of our top line guidance metrics in Q4. Our performance over the past couple of years not only exemplifies our unwavering focus on delivering customer success, but is a testament to the innovation and flexibility that Now Platform provides to our customers. Whatever the macro challenges were, ServiceNow adapted to deliver value.

ServiceNow’s ability to quickly respond to the needs of enterprises when and where they require us most is why we’ve become a trusted digital platform to drive transformation. It’s why our renewal rates are best-in-class, creating a solid foundation from which we grow upon each year. It’s why in 2021 we added more incremental subscription revenues than we reported in 2016. I am going to pause there for that to think in. In 2021, we added a whole other 2016 ServiceNow to the top line, incredible organic growth at scale, while generating over 30% free cash flow margins.

Now turning to our Q4 results. Subscription revenues were $1.523 billion, growing 30% year-over-year in constant currency. We exceeded the high end of our guidance range by $3 million, when adjusting for the incremental $15 million FX headwind we saw in the quarter we beat by $18 million. RPO ended the quarter at approximately $11.5 billion, representing 32% year-over-year constant currency growth. Current RPO was approximately $5.7 billion, representing 32% year-over-year constant currency growth and nearly four point beat versus our FX adjusted guidance.

Q4 subscription billings were $2.420 billion, a $110 million beat versus the high end of our guidance. This represents 32% year-over-year growth on a reported basis and 33% year-over-year growth on an adjusted basis as FX and duration were a headwind of 100 basis points.

From an industry perspective, energy and utilities more than doubled its net new ACV contribution from the year ago period. Business, services and healthcare life sciences also had a robust Q4 at very high double-digit net new ACV growth. Our renewal rate was a best-in-class 99% continuing to demonstrate the stickiness of our business as the Now Platform remains a mission critical part of our customers operations. These enterprises not only remain loyal ServiceNow customers, but our customer cohorts have continued to show solid expansion over time.

As of the end of Q4, we had over 1350 customers paying us over $1 million in ACV. Our strategy of targeting the right enterprise customers that drive the best ROI and can grow with us over time is bearing fruit. In Q4, we closed 135 deals greater than a million in net new ACV in the quarter, up over 50% year-over-year. In addition, our better together story is resonating as 18 of our top 20 deals included five or more products.

Turning to profitability, operating margin was 23%, 1 point above our guidance, primarily driven by the strong revenue beat. Our free cash flow margin in the quarter was 46%. Our full-year 2021 operating margin was 25% and free cash flow margin was 32%, representing $1.9 billion of free cash flow. We ended the year with a healthy balance sheet, including $4.9 billion in cash and investments, putting us an excellent shape to continue investing in strategic initiatives to drive organic growth. Together, these results show the power of our business model and our ability to drive a balance of growth and profitability.

What’s more? We’re achieving all of this with the focus on ESG and winning the right way. Last quarter, I announced our commitment to reaching our net zero emissions goal by 2030, two decades earlier than our previous goal. This quarter, you heard Bill introduce Karen Pavlin, who will lead our efforts to strengthen our culture, ensuring equity, and creating an even deeper sense of belonging. Diversity equity inclusion are business imperatives to ServiceNow.

In 2021, we outperformed all six of our representation in hiring goals across three categories: Black, Hispanic and Latinx, and women in leadership. At its core, ServiceNow’s culture is one of belonging. It is core to who we are and one of the keys to our company’s growth for many years to come.

Moving on to guidance. Since the end of Q3, we’ve seen an incremental strengthening of the US dollar, resulting in material FX headwind in 2022. To help provide investors better visibility into the underlying strength of the business, I’ll be providing constant currency guidance.

I would also note that in January we completed an assessment of the useful life of our data center equipment and determine that we could extend our estimated life from three to four years. As a result, we expect a reduction in depreciation expense, which will contribute approximately 100 basis points to gross margin in 2022, trending down to just 50 basis points in 2024.

With that in mind, I’ll turn to our 2022 outlook. Last year was a strong year and I’m excited to announce that our momentum will carry into 2022 as we do not expect any change in constant currency growth year-over-year. We expect subscription revenues between $7.02 billion and $7.04 billion, representing 26% year-over-year growth, that’s 28% on a constant currency basis, the same growth as 2021. It’s an amazing achievement when you think about the fact that the base we are growing up is $1.3 billion higher when we started just last year. We expect subscription gross margin of 86%, up 100 basis points year-over-year. We expect an operating margin of 25%.

With regards to operating expenses, we have reopened many offices and are planning in-person conferences end user events this year. Our sales force has also already begun to travel again. As such, we expect certain COVID-related savings we’ve seen over the past two years to say in 2022. We expect free cash flow margins of 31% and we expect diluted weighted average outstanding shares of $204 million.

For Q1, I’m pleased to announce that we expect subscription revenue growth to accelerate year-over-year on a constant currency basis. We expect subscription revenues between $1.61 billion and $1.615 billion, representing 25% year-over-year growth or 27.5% constant currency growth. We expect cRPO growth of 28% year-over-year or 29.5% on constant currency basis. We expect an operating margin of 25% and we expect $203 million diluted weighted outstanding shares for the quarter.

In summary, we had a very strong Q4 and I am so proud of what our team has accomplished over the past year and what they continue to achieve. The pace of digital investment is accelerating. Demand in 2022 continues to be strong. Enterprises are turning to ServiceNow to create new business models to address the new ways employees and customers want to engage. The Now Platform offers the speed, flexibility, and innovation companies need. We’re well on our way to $15 billion and beyond and becoming the defining enterprise software company of the 21st century.

Before moving on to Q&A, Bill and I want to thank our employees around the world for a tremendous year. You are the key to ServiceNow’s success and you will continue to make us ServiceNow strong.

And with that, I’ll open it up for Q&A.

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from the line of Phil Winslow with Credit Suisse. Your line is open.

Phil Winslow — Credit Suisse — Analyst

Hi, team. Thank you for taking my question and congratulations on a strong — into a really strong full-year. Investors have been concerned this year about a potential pull forward demand, really setting the stage for decelerating growth across software. Now, looking at your results tonight and the guidance, I really can’t find any signs of decelerating demand for ServiceNow. In fact, sales and marketing headcount Q4 grew at its fastest rate since Q1 2020. We suggest you’re continuing to lead in here.

So two questions. First, Bill, my question to you is, what are you hearing from customers that gives you confidence and sustainability of growth and to accelerate this go to market hiring exiting the year end? Gina, what trends are you seeing in terms of ramping at these new sales and marketing hires? Thanks.

Bill McDermott — President and Chief Executive Officer

Thank you very much, Phil, for your kind remarks and also for your question. Customers are absolutely focused on technology being the business strategy and digital transformation is in full-flight and we will capitalize on that greatly. The reality on our numbers is we did not see any evidence of unusual demand pull forward into our business for 2021. It happened in an extremely linear and coherent fashion, which was really I think the beauty to watch from an execution perspective.

And as I look at the pipelines, they are ever increasing and they’re doing that across the platform, the employee experience, the customer experience, the creator experience. And all of this now is really making ServiceNow one of those real standard platforms for well-run companies in the 21st century. And I think that includes a very short list of others. We are one of them. And Phil, the business just couldn’t be going better.

Gina Mastantuono — Chief Financial Officer

And then, Phil, on your question with respect to ramp reps, you’re absolutely right. We did not pause at all on our head count growth in Q4. We’re entering 2022 with more ramp sales reps than we entered 2021 and we feel really good about pipeline and the demand that we see in front of us. So we are absolutely not stopping our investment in go-to-market resources. We are planning for a very strong 2022.

Phil Winslow — Credit Suisse — Analyst

Awesome. Thanks, team. Congratulations again.

Bill McDermott — President and Chief Executive Officer

Thank you, Phil.

Gina Mastantuono — Chief Financial Officer

Thank you, Phil.

Operator

Your next question comes from the line of Raimo Lenschow with Barclays. Your line is open.

Raimo Lenschow — Barclays — Analyst

Hey, congrats from me as well. Well done. Can we talk a little bit about the revenue you are achieving with one of your biggest clients you have, like a record number now of people over 1 million in ACV, but the ACV numbers also going up like — Bill, can you talk a little bit about how you see this trending going forward with all the different products that you have, but also the product expansion that you’re seeing there? How do you think this will evolve over time? Thank you.

Bill McDermott — President and Chief Executive Officer

Raimo, excellent question. This is really a beautiful point in the scale phase that ServiceNow is in. And you might notice the substantial promotions for CJ in addition to taking on is normal great results for development and engineering. He is now moving into the industry phase where we’re going to connect the code to the actual industry specific solutions, these specialist professionals that guide our general line sales force and our customer relationships each and every day. And that’s going to give us a real special bilateral communication with our customers to innovate at an even faster clip than we have in the past at best possible.

And you see what happens in telecommunications, in financial services, you see what happens in government, healthcare, life sciences, all the businesses that we’ve chosen to focus on from an industry perspective are really scaling and doing so very, very quickly. Here’s where the big deals have only just begun. If you look at businesses today and there is one retailer in particular that I referenced in the call like CBS, which is a great company, they have retail customers, but they were also transforming into a health and wellness company and they understand the experience that they have to give their customers is evolving into a multi-workflow environment.

So on one hand I have to keep my associates super happy, because they have complex enough jobs, I have to keep my customers happy, because in some cases they want to come to the store and other cases they want the store to come to them. On transforming my business model between all of these factors and now I’m going to health and wellness in Sunday, I’ll not only do that in store, but I can do that at the home. So you’re seeing multi complex workflows possible on the Now Platform coming together to form greater sized solutions that have major business impact for our customers and the value we can create with digital transformation.

So the challenge I’ve got out to the company, Raimo is the large deals will accelerate dramatically on a year-over-year basis. We are now prepared for that. And we have the best leaders in the positions in the company to deliver that and we have an extremely inspired workforce and extremely inspired ecosystem. So all that comes together. And as you know I’ve seen the movie before, when it all comes together, it equals big growth.

Raimo Lenschow — Barclays — Analyst

Very exciting. Thank you.

Bill McDermott — President and Chief Executive Officer

Thank you.

Operator

Your next question comes from the line of Alex Zukin with Wolfe Research. Your line is open.

Alex Zukin — Wolfe Research — Analyst

Hey guys, congrats on a great end to the year. Bill, maybe the first one for you. If you think about what you just said to Raimo’s question about being in a great position to massively accelerate the amount of large deals. Is it right to kind of think that industry clouds and the low-code platform vision that’s the big motion that you think will unlock the most value in some of these larger deals even more — maybe even more so than HR CSM, what’s the right way to think about like the growth drivers of these expansion opportunities over the course of the next year? And look it doesn’t escape all of us the valuation contractions we’ve seen in the public markets, does it change or in any way influence your strategy or thought process around organic versus inorganic growth?

Bill McDermott — President and Chief Executive Officer

Yes, Alex, that’s a really significant set of issues and I’ll address them head on. First of all, every great company has a great core business, because when you have a multibillion core business, that core business has to perform, so you get the leverage on all these adjacencies. Our core business is better than ever and it’s growing really strong. And in fact I think it could be very close to the overall corporate growth rate as we look into the crystal ball. Then you add on employee experience. You have to remember this employee experience in the future of work and where people are going to be working and how they’re going to be working especially exacerbated by a talent war out there. It’s really a big deal.

And CEOs need to retain the people they have now. They better be recruiting and onboarding in a flawless manner, because the employees today expect consumer grade user experiences in the enterprise. And if they don’t get them, they either don’t come on in the first place, because they know what’s going on in these companies, the Internet tells them that. Or when they get there, they don’t stay very long because they are not happy. So the employee experience is front center.

And then on customer service management, the reality is this is just starting, because the world is really acknowledged that the customer is not going to come to you the way they used to. You may have to go to them. And you have to explain to their customer that your brand gets it and you can give them an experience no matter where they are experiencing your brand that has enormous consistency service value. And yes, even helpful hands in terms of smart transactions through an AI platform like ServiceNow.

And then you take the creator workflow, look 500 million applications between now and the end of 2023 is more applications that have been built in the last 40-years, so there is no choice. It’s going to be low code, no code and the ServiceNow platform is beautifully positioned.

Now let me extend to your question on industry and low-code, that is absolutely a very astute observation, because if you take the low code revolution and you combine it with industry, we’re now solving business problems that have been out there for a long time. We featured the Celonis partnership where they can do the x-ray in the non-ServiceNow installed environments. We can activate all the changes that are necessary to augment the business process on the Now action layer. And, of course, [Technical Issues], all those systems out there have been mass customized. But with ServiceNow, you can carry forward all your customizations with the creator workflow. You don’t need a team of consulting centers and a truck coming over there for years and years projects and billions and billions. This is speed to market. This is low cost of rollout of big ideas and business model innovations and better service for be employee and the customer.

So it all comes together and the reason I’m so excited about what we’re doing with the executive team here is we’re all lined up now to take everything we know how to do and scale it across the world in every geo and every industry and every persona. And I have to thank my partners out there. I mean, they’re knocking down the door to get a bigger piece of the ServiceNow franchise. So it’s all of those things coming together, Alex.

Now on M&A, I want to be really super clear about this. We have no targets on the board for M&A. And the reason for that is on an organic growth basis, you see the numbers as much as I see the numbers, the cloud economics are in full-flight. And we have engineers that love this company and they love coming to work every day whether they’re working out of their home or out office, we’re all open. And they come in and they create new things. And they have an idea that they can take and they have a dream that they can build.

When I listened to other engineers and other software companies that want to come over here, tell me they spend 90% of their time integrating the past as opposed to innovating the future. It just reminds me of how thoughtful we have to be on M&A. So as Gina said, we have $5 billion in cash, that’s going to continue to grow exponentially you know that. We’re fueling our organic growth ambitions. We can be opportunistic, but in this guide and this current state of affairs, there is no intent to do any large-scale M&A. And if that were to change, I would be the first to tell you.

Alex Zukin — Wolfe Research — Analyst

Incredibly specific and we all love the candor and appreciate that color. I guess maybe just a quick follow-up. First of all congratulations to CJ, what a wonderful expansion of his abilities and opportunities. I wanted to ask about the shift on the Chief Customer Officer. What plays — worked as an example, in other company has made a move to historically make the Head of Europe the head of overall sales. I wanted to ask what in terms of the motion that you’re seeing successful in outside of the US that can be applied to the rest of the organization and particularly inside the US. What plays are successful that you think can be run or expanded that work.

Bill McDermott — President and Chief Executive Officer

Well, first of all, I want to tip my cap to our Regional Presidents, because they know I love and I love all of them. We have great leadership with Mitch and APJ, great leadership with Mike in the Americas and now Ulrich coming on in EMEA. I know them all personally. I admire them deeply and I really appreciate what they’re doing for ServiceNow. And they’re all playing critical roles in our future. Mike, as an example, has done extraordinary job here for very, very long period of time and 65% of the number resides in his pack. So he knows what we think of him. And I’ve always told our leaders that this is a significant company and each piece of this puzzle needs to be managed with incredible care and these are the leaders that will do that.

Now Paul Smith brings very unique style and know-how especially around the expansion of the C-level relationships where he has proven himself in an exemplary fashion for the 18-months that he has been here. And as you know, we had a great track record before he got here. And he understands all the concepts that I put out on this call today, because he’s been through them and we’re activating them together. And we all know exactly what we are doing.

And the other thing is with CJ and the closeness that CJ and Kevin have had all these years that continues. Kev is still — when they — and CJ is right when they and Paul is right when they, so we are all putting this together and we’re going to activate in every region and every industry and across every persona. And what I’m so inspired by is these executives. I respect them with my whole heart and they are doing a fabulous job and they want ServiceNow to be defining enterprise software company of 21st century. And they all want it as badly as I do, which is why I know it’s going to happen.

Alex Zukin — Wolfe Research — Analyst

Thanks so much guys and congratulations.

Bill McDermott — President and Chief Executive Officer

Thank you very much.

Gina Mastantuono — Chief Financial Officer

Thanks, [Indecipherable]

Operator

Your next question comes from the line of Kash Rangan with Goldman Sachs. Your line is open.

Kash Rangan — Goldman Sachs — Analyst

Hi, what an incredible finish year ’21 you have, more than $5 billion in revenue and you have close to $11 million plus in RPO that you are hardly with inside of your long-term goal, Bill and team, so kudos on that wonderful milestone. Bill, my question for you is certainly your vision of the platform revolution taking over from the database — relational database, middleware that whole stack, while revolution is a very compelling one, because you can bring value to customers pressing problems immediately, right. So that’s been the long-term thesis of ServiceNow?

Now little bit more tactically, as you head into ’22, we’ve got no need to reiterate, but very briefly inflation pressures, labor shortage, supply chain shortage and a need to boost productivity, despite all these constraints. How do you see the Now Platform being a crypto handle these challenges, these tactical challenges in the near term for corporations with your execution? Thank you so much.

Bill McDermott — President and Chief Executive Officer

Well, I really appreciate the question. Thank you so much for your kind remarks, I really do Kash, thanks a lot. ServiceNow, you know, has a unique ability to drive more efficiency and automate these processes. And is absolutely a deflationary tool that helps alleviate the need for more hiring, many companies think the only way to stop to store more bodies at it. While we have no quarrel with increase in jobs, if there is a limited pool of digital assets, that’s a problem. And that’s why you need ServiceNow.

So driving the productivity and efficiency out of the resources enterprises already have, helping them reduce the need for additional spend is our lead play in the playbook for the scenarios you laid out there. And one simple example, take virtual agents deflecting and automating tickets so that the IT help desk personnel can spend their time tackling more strategic issues given them more satisfaction with the job and creating a happy work environment. And this also reduces the need to hire more people in the first place with really smart CEOs are literally struggling every day now how I keep my people. And the only way to keep them is to give them a great experience. And they are going to feel you right out of the gate. If you recruited on and you can’t onboard them properly, did that feel you, if you can train them and activate a customized training curriculum that’s targeted specifically to their unique skills and attributes. And they’re going to feel you real quick if they can go to one portal to activate all of their services on their mobile device.

So no matter where they are, their company, their company’s brand, their company’s culture is talking to them. And then you do need to manage these cases with people. My goodness, legal could be involved, finance could be involved, HR could be involved, COOs and CEOs could be involved. And most companies have literally 1,000 of cases that are inflated at any one time. Only ServiceNow can manage the multi-disciplinary workflows that go across an organization in many different circular forms to close out a case properly. That’s what we do, Kash.

So I lean into the inflation conversation, the labor conversation. We’re more and more activated now and straightening out supply chain dilemmas. We have one manufacturer in the auto industry that has us as the control tower for their entire supply chain now. A few years ago, nobody would even know that. We are solving ERP cases left, right and center with ServiceNow as the action platform. So I think the idea of this productivity and I mentioned in my discussion earlier really manifest itself in our new impact product. We took a service, productized it in software, where we can look at the entire value chain on the Now Platform.

The entire value chain from the pre-sale to the sale and the post sale all the activities that are taking place in the deployment in relation to the value that’s being delivered in real time with hard dollars and cents and an absolute measurement that the customer can look at on their iPhone that the partner participate in the conversation into that we’re not using any other technology, but the Now Platform and that ServiceNow can use.

So now just think about the gorgeousness of that conversation where as we deploy, we can show the business outcome and the partner and ServiceNow and the customer are all on the same sheet of music on the Now Platform with ServiceNow Impact. Kash, it’s amazing. We had 17 customers in the pilot join up on the Impact platform before we even launched it with Now GA on it and we’re launching it with all of our employees globally tomorrow every geographies. This is going to create a renaissance of value delivery in the enterprise, the likes of which has never been seen before.

Kash Rangan — Goldman Sachs — Analyst

Profoundly exciting. Thank you so much, Bill.

Bill McDermott — President and Chief Executive Officer

Thank you, Kash.

Operator

Your next question comes from the line of Keith Weiss with Morgan Stanley. Your line is open.

Keith Weiss — Morgan Stanley — Analyst

Excellent. Thank you guys for taking the question. And let me echo the congratulations on a great quarter and a great year. I want to follow through on Kash’s interesting question and kind of turn it inward to ServiceNow. Bill, from your perspective, do you see any constraints in terms of your partners finding the people or your customers finding the people to be able to deploy ServiceNow? We’re hearing about that in some of our checks and some of the systems integrated to such a tight labor market. Are the people there to sort of deploy the solution or could that could that become something of a friction to just getting ServiceNow up and running?

And to Gina, are you seeing any incremental or increased wage inflation in terms of sort of — you guys are hiring very aggressively and I think headcount for 29% year-on-year, so you’re definitely finding the people, is there any increase in wage inflation or anything extraordinary on that side of the equation given that tight labor market that might impact margins on a go-forward basis?

Bill McDermott — President and Chief Executive Officer

Thank you very much for the question, Keith. As I mentioned earlier, we are one of the significant partners to the global SIs. So if you look at the top five technology partners for the top 10 SIs, we’re one of them. So while they may have some difficulty hiring to meet demand, we are getting preferential resource allocation, not only as a top five technology partner, but also because our swelling pipeline and our growth is so amazing that they all want more of that real estate. And where they have less interesting growth scenarios with other partners, they are actually peeling off head count in favor of the ServiceNow practice. This is happening all in place.

In addition, one of the things we have done as we took matters into our own hands and built out academies and we’re doing more for university programs to meet the demand, the ServiceNow trained talent and I note that we’ve also been working with our partners to sponsor and engage with local diversity profit, non-profits to target diverse populations for next gen skill development, which will help alleviate such labor shortages in the future. We have to initiate people into the digital world that perhaps aren’t initiated, but it’s certainly more than capable. And I always go back to the root cause why ServiceNow is so special.

When Fred Luddy created this company, he created a platform that was a sensation. And it was designed to give people productivity, a tool to enable them to do things with their lives and their jobs that they could never done without it. And I think that level of simplicity and agility and the general construct of the platform make it so much easier for people to learn and develop and grow on it and now they see where we’re going. They know it’s a growth sensation. And you know how it is, rising tide lifts all boats and everybody wants to get on this one.

Gina Mastantuono — Chief Financial Officer

And then Keith, on your question with respect to labor inflation rates, enterprise software talent has been in high demand for some time now. So competitive compensation has been on the rise and it’s not new for us. We continue to monitor it. We definitely anticipate some continued pressure in the coming quarters, but we remain very committed to our margin guidance that we’ve given you for 2022 and beyond.

Kash Rangan — Goldman Sachs — Analyst

Outstanding. Thank you so much for the detail.

Gina Mastantuono — Chief Financial Officer

Thanks, Keith.

Bill McDermott — President and Chief Executive Officer

Thank you, Keith.

Operator

Your next question comes from the line of Michael Turits with KeyBanc. Your line is open.

Michael Turits — KeyBanc — Analyst

Hey, thanks very much guys and congrats on the quarter. One for Bill and one for Gina. So Bill, I want to talk about a couple of submarkets that you have made acquisitions and specifically in RPA and observability? And how you’re thinking about those markets and your strategy with this will be really directed at existing larger ServiceNow implementations? Or how directly you’re going to go into those types of deals? And then something for Gina.

Bill McDermott — President and Chief Executive Officer

Yes. Of course. Well, Michael, thank you very much. First of all, we are very excited about Ben, his leadership and the whole Lightstep team. As you know, they have been doing a great job winning amazing forward thinking brands and they have been doing a phenomenal job culturally integrating back into ServiceNow. So we are going to begin going to market with Lightstep and that’s going to be at mass scale and that will be announced at the employee kick off tomorrow, so that’s exciting. And the work with Lightstep to not only serve the needs of IT, but to observe things in a way that can be consumed across the value chain of decision makers at an enterprise is pretty big.

And then RPA, this whole process mining, RPA and AI, the platform for hyper automation is the ServiceNow platform. That’s a huge point. And CJ and his great team, unbelievable team, they are making a major release in RPA as you know in our San Diego release. So more and more customers will benefit from the power of the ServiceNow platform, including RPA built into the San Diego release. It’s an exciting release. What Amy Lokey and the team have done also on the user experience mean we, sort of, demonstration of it with the board, it’s unbelievable.

You know when you’re dealing with ServiceNow, because you can have one gorgeous user experience and it doesn’t matter, what area of the platform you’re looking to enable, it’s all one gorgeous user experience. And I mean, I’ve never seen anything better. And it is the scale story all the away. And when we hit Tokyo in September, I hope to be in Tokyo with that announcement, because I want to reach out to my great friends in Japan as a Japanese expression [Foreign Speech]. And that underscores the spirit of ServiceNow to be better than the best. And that’s the standard that we hold ourselves to. And the marketplace in Japan is really getting a memo on the power of ServiceNow and what we can do to liberate them into the cloud and that’s going to be an exciting part of our growth story.

Michael Turits — KeyBanc — Analyst

Great, thanks, Bill. And then Gina, just some clarifications on the extension of the useful life. So you’ve guided essentially to flattish op margins, but down a bit by 70 bps on free cash flow. So I just make sure that I understand it — that I was — you get that benefit to EBIT margins, but that’s closed when we see it on free cash flow. So this is just a non-cash and you’re actually including expenses. So, we make sure those mechanics are right. And then also do you get in year two of this — do you get to that tailwind to EBIT an accrual — does that flip around to a headwind on EBIT margins and gross margin?

Gina Mastantuono — Chief Financial Officer

Great question, Michael. So you’re absolutely right. The benefit that you’re seeing this year hit EBIT and operating margin, but not free cash flow, right, because it’s just a change in depreciation, which is a non-cash, right? So that’s the reason why you’re seeing the benefit in operating income, but not a free cash flow.

What you are seeing in free cash flow is the increased cost that I’ve been talking about as the COVID saving start to fade in ’22 as we come back in person for digital events and in-person events and travel. With respect to the longer-tail of this change in depreciation, it definitely tapers off and get smaller, right? So it’s 100 basis points benefit this year by 2024, it goes down to just 50 points, right? And that’s only on the EBIT margins, not on free cash flow.

Michael Turits — KeyBanc — Analyst

Okay. Thanks very much, Gina and Bill.

Gina Mastantuono — Chief Financial Officer

Of course. Thank you.

Bill McDermott — President and Chief Executive Officer

Thank you very much. Appreciate it, Mike. Thank you.

Operator

Your next question comes from the line of Brad Zelnick with Deutsche Bank. Your line is open.

Brad Zelnick — Deutsche Bank — Analyst

Great, thank you. Bill, Gina, my congrats as well to you and the entire team and especially to CJ and the others. They are so deservedly being elevated within the organization. Bill, you personally have been serving enterprise technology customers for many years. And many of us have been students of the industry for a long time as well. And I hesitate to say this, but it feels like this time is different. This digital transformation freight trend just keep steamrolling down the tracks. And rather than ask you to tell us about the environment which is obviously very strong for what ServiceNow delivers, I would instead ask you if you agree with my characterization, why do you think this time might be different?

Bill McDermott — President and Chief Executive Officer

Thank you for the question. It is entirely different. It is entirely different, because the technology that is available to customers today can be so transformative and I believe strongly that the Now Platform from ServiceNow is literally the control tower, the platform for digital transformation with digital business. And the reason I feel so strongly about that is the enterprise has been sold behind in consumerising experiences for people.

And now with ServiceNow, these leaders of companies can finally say, “uh, all I hear is good news.” My HR leader tells me that all the continuous [Phonetic] of the past goes away with ServiceNow and my people are happy and they’re getting what they need. My head of revenue is telling me, wow, we could finally now do all the remote heavy thinking in diagnostics in a fully digital way and we can bring our story to the customer and have that frictionless digital experience that’s easily repeatable, drives tremendous customer SAT and NPS and creates the loyalty effect. Wow, we’re finally there.

And then we can finally breakthrough, you know, where companies are trying to refresh old applications, they can say, “wow, now I can empower my people. They can build the new innovations. They can refresh the old, but build the new innovations and tech is the idea of liberating, not replacing people and creating more economic value and value-add, plus every young person doesn’t want to work for just a paycheck. They want a purpose. And I think our purpose to make work better for everyone is absolutely the right way to go and I think that the leaders of companies want that for their company.

And therefore, I think the confluence of all of this on one platform with one consumer-grade user experience for all people, whether they’re inside or outside the company, a platform that can take cost out and build revenue in is what this generation is waiting for. And once people are aware of ServiceNow, we win every time. So one of the moves that we’ve made and I’m sure you’ve seen the pivot with the world works with ServiceNow is bringing the world the brand that it deserves from ServiceNow.

And I think that’s going to really turn on a lot of people to say, ah ha, I might have been a C-level decision-maker, then knew my IT people were happy with ServiceNow, I just never knew why. Once I started to learn about it or asked about it, now I know that they can activate transformation in all dimensions of my company, not the least of which is be the action layer for the whole enterprise. And I keep telling people when I meet with the CEOs like we have good systems of record. They’re all very fine. But I don’t use them. We only use ServiceNow to run ServiceNow and that’s why our peoples are so happy because everything works.

Brad Zelnick — Deutsche Bank — Analyst

Awesome. Thank you for the perspective, Bill.

Bill McDermott — President and Chief Executive Officer

Well, thank you, Brad. Thank very much.

Operator

Your next question comes from the line of Pat Walravens with JMP Securities. Your line is open.

Pat Walravens — JMP Securities — Analyst

Great, thanks very much. Bill, congrats on the terrific results and outlook. I love hearing the enthusiasm. Could you drill down deeper for us on the relationship with Celonis and how ServiceNow, Celonis worked together to solve customers’ problems?

Bill McDermott — President and Chief Executive Officer

Yes, I absolutely will. And thank you very much for your kind remarks. I really appreciate it. I want to go back a little bit in time on this one. There once was a time where these gentlemen graduated in Technical University of Munich, we call it TUM over in Germany. And I got to know Alex very well several years ago and also his Co-Founders and we built a very strong friendship. And he used to laugh, because he sent me a note in December telling me about this business and within a few minutes I get back to him and he never forgot that. And I still get back to him within a few minutes and we still have a great friendship.

And we know that we have to liberate the past and move it into the cloud. We know we need to put it on an automation platform that can really change business. And therefore in the non-ServiceNow environments especially where it’s an ERP environment, Celonis does a very good job in the process mining to actually understand where the brakes are and the opportunities are in the business process to drive business productivity and performance.

It is on that basis that we said, look, we should team on because our customers more and more are asking us to get involved, automating back-office business operations and business processes with the Now Platform. So we are essentially taking this relationship and applying automation that truly moves the needle for organizations to understand how workflows across the people, processes and systems of their companies. And we’re helping map those elements in real-time and building digital workflows to more efficiently automate work, because the x-ray by itself doesn’t really help. We have to then put it on the action platform to actually automate it to drive a result.

So our engineering teams have created a seamless product experience that’s going to make it easy and simple for customers to get the insight into the process across multiple, I might add, enterprise systems and they’ll use Celonis EMS platform and convert that insight into action automation and remediation with the ServiceNow workflow platforms. And when you bring together process mining, automation, machine learning, RPA and low-code app development and this touches on a question that came up earlier, low-code app development into a seamless product experience, customers will enable quick continuous improvement with the flow of work.

And I stress quick, because — and this touches on earlier very small question. These opportunities haven’t been there for customers in the past and they’re only going to start learning about them now, which is why I see an even bigger hockey stick as we look into the future, because we can revolutionize all the installed base problems into new market opportunities in the cloud that are just sensational in terms of the business value they drive for corporations all over the world.

Pat Walravens — JMP Securities — Analyst

Okay, that’s super helpful. Thank you, Bill.

Bill McDermott — President and Chief Executive Officer

My pleasure. Thank you for the question, Pat.

Operator

We have time for one more question. Your last question comes from the line of Drew Glaeser with JPMorgan. Your line is open.

Drew Glaeser — JPMorgan — Analyst

Hi, this is Drew on for Sterling. I was just wondering how the government vertical performed in the quarter and whether you could provide some more detail on that?

Bill McDermott — President and Chief Executive Officer

Yes, I’d be happy to. Our government business is truly a growth story at ServiceNow that is very, very special. So we look at the tailwinds in the US Federal market. It came through very strongly. It’s a big opportunity for us. What’s happening through as many of these agencies, they need or they have a mandate actually to digitally transform. One of the mandates is the President’s Management Agenda or PMA, their vision is the administration’s guide to invest and the government’s capacity to deliver better results. And it’s aligning with ServiceNow’s core offerings. So, for example, if you look at the pillars, it’s all about strengthening and empowering federal workflow and the workforce. It’s sharing data, sharing business processes, looking at things across boundaries. They have delivered excellent equitable and secured federal services and customer experiences. This is driving acceleration for better customer service.

If you look at their pillar three, it’s managing the business of government and they want to make sure the systems work well, so this is all about business resiliency. Now our cloud is extremely resilient and they’re focused also on cyber security and I think you’re familiar with that and the role that we can play in having a control tower or all the things going on from a security perspective. We can help other people’s solutions also tie into that control tower effect to manage the nation’s cyber security and obviously avoid recent ransomware attacks in other banks. They are also focused on vaccine management.

And we said a long time ago, I believe this was in March of 2021, we said this that the old vaccine management process would be the greatest workflow challenge that government faces maybe in our lifetime. And as you know, we have the world’s leading solution for that with entire countries. Of course, part of the United States, Germany, Scotland, many countries including — and Asia running on the Now Platform for vaccine management and returning to work safely and so forth.

So all of this netted out basically says that at the federal, the state, the local, the university and all public entities combined are focused on transforming digitally. They have to take these paper-based slow dangerous processes and put them in order. And the only way to do that is work from home, digitize them and then execute the mission of government serving the people and that’s why the public sector now represents double-digit of the Now business, about 10% of our business.

And look with the problems with government has been digitizing things, this should be one of the more sensational industry story for us for a long, long time, which is one of the reasons why the great Kevin have already an eye, will be working very, very closely on the public sector initiative globally and his new capacity.

Drew Glaeser — JPMorgan — Analyst

Got it. That’s very helpful. Thank you.

Gina Mastantuono — Chief Financial Officer

Thanks, Drew.

Bill McDermott — President and Chief Executive Officer

Thank you very much. Appreciate it, Drew.

Operator

[Operator Closing Remarks]



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Invesco Dividend Achievers ETF: A Bloated Fund Not Worth Buying

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IvelinRadkov/iStock via Getty Images

Investment Thesis

The number of companies that have increased dividends for at least ten consecutive years is growing, and with each passing year, this once-admirable dividend growth streak gets less impressive. The Invesco Dividend Achievers ETF (NASDAQ:PFM) tracks these 373 companies, but due to its market-cap-weighting scheme, it ends up being too similar to an S&P 500 Value Index fund. For 0.53% in annual fees with no quality screens, it makes sense that PFM has been an average-at-best long-term performer. I expect it will remain that way in the future, and therefore, I am limiting my rating on PFM to a hold.

ETF Overview

Strategy and Fund Basics

PFM passively tracks the NASDAQ US Broad Dividend Achievers Index, selecting constituents with at least ten years of increasing annual regular dividend payments. Reviews are once per year in March, and the Index is market-cap-weighted with a cap of 4% per security at each quarterly rebalancing. As a result, PFM is more concentrated than you might think. I’ve listed some additional statistics below for easy reference:

  • Current Price: $38.68
  • Assets Under Management: $735 million
  • Expense Ratio: 0.53%
  • Launch Date: September 15, 2005
  • Trailing Dividend Yield: 1.87%
  • Five-Year Dividend CAGR: 7.79%
  • Ten-Year Dividend CAGR: 6.08%
  • Dividend Frequency: Quarterly
  • Five-Year Beta: 0.85
  • Number of Securities: 373
  • Portfolio Turnover: 28% (6%, 5%, 13%, 20% From 2017-2020)
  • Assets in Top Ten: 25.05%
  • 30-Day Median Bid-Ask Spread: 0.05%
  • Tracked Index: NASDAQ US Broad Dividend Achievers Index
  • Short-Term Capital Gains Tax Rate: 40%
  • Long-Term Capital Gains Tax Rate: 20%
  • Tax Form: 1099

One positive feature is that PFM is a low-turnover ETF. It makes sense, given that qualifying companies are likely to maintain their dividend growth status. There’s a good chance PFM will have many of the same securities in five years as it does today, so passive investors will appreciate not having to check in each year as the Index reconstitutes. On the downside, the Index is becoming so watered down that ten consecutive years of dividend increases are no longer impressive. In my view, investors need additional quality or valuation screens.

Sector Exposures and Top Ten Holdings

The table below highlights sector exposure differences between PFM and three other funds: the SPDR S&P 500 ETF (SPY), the SPDR S&P 500 Value ETF (SPYV), and the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). NOBL requires 25 consecutive years of dividend increases, so it’s the next level up for those valuing dividend consistency.

PFM vs. SPY vs. SPYV vs. NOBL Sector Exposures

Morningstar

Based on these exposure levels, PFM may be considered a cross between SPY and SPYV, primarily because of its high exposure to Technology and Consumer Staples stocks. Notably, it lacks any meaningful exposure to Energy and Materials stocks, which are often commodity-driven. This feature is a key reason for PFM’s recent underperformance against other large-cap dividend ETFs. This will probably continue, too. Stocks in these sectors are less likely to reach ten consecutive years of growing dividends because commodity prices are cyclical.

PFM’s top ten holdings, which total one-quarter of the ETF, are shown below. Microsoft (MSFT) is one of 26 Technology stocks in the Index, while three Health Care stocks make the list. They are UnitedHealth Group (UNH), Johnson & Johnson (JNJ), and Procter & Gamble (PG). According to Global Industry Classification Standards, Visa (V) and Mastercard (MA) are also considered Technology stocks.

PFM Top Ten Holdings

Invesco

Historical Performance

Historically, PFM looks closer to an S&P 500 Value fund more than anything. Its annualized returns are almost identical, but it did experience less volatility. As a result, its risk-adjusted returns (Sharpe and Sortino Ratios) were slightly better. Still, PFM trailed SPY by 2.89% per year, which, over 16.5 years, means an underperformance of 124%.

PFM vs. SPY vs. SPYV Performance History

Portfolio Visualizer

In fairness, most of this underperformance came in the last five years, and PFM was a solid product up until then. The graph below shows the abrupt change in five-year rolling returns around 2016.

PFM vs. SPY vs. SPYV Rolling 5-Year Returns

Portfolio Visualizer

ETF Analysis

Dividend Growth and Yield History

Since all constituents have grown dividends for an extended period, I doubt dividend safety and consistency are an issue. However, the degree of dividend growth is often a problem. PFM’s trailing yield is only 1.87%, so I think investors need some steady growth over time to be a worthwhile long-term investment. The graph below shows that this growth is meager – only 5.19% annualized in the last 15 years.

PFM Dividend Growth History

Seeking Alpha

The growth in 2017-2018 almost offsets each other, so the figures may be difficult to interpret. Instead, I’ve graphed the distributions on a trailing twelve-month basis and included the yield on each ex-dividend date to give a better picture. You can see that distribution growth isn’t linear but has increased at a reasonable rate over the last ten years. From March 2012 to March 2022, trailing distributions rose from $0.3339 to $0.7216, or an annualized 8.01%. Yield has been more volatile, of course, but it’s worth noting that the yield hasn’t been this low since December 2017.

PFM Trailing Twelve Month Dividends and Yield

The Sunday Investor

Dividend Scorecard

Seeking Alpha’s Dividend Grade for PFM is an “A-,” but as mentioned before, dividend growth is my main concern because I don’t think there’s an issue with safety and consistency. To analyze this in more detail, I’ve calculated weighted-average ratings for PFM’s top 20 industries, which total about two-thirds of the ETF. The net ratings for the entire ETF are at the bottom, alongside ratings for NOBL, which is probably a reasonable alternative if you favor a long dividend growth streak.

PFM vs. NOBL Dividend Scorecard - Data From Seeking Alpha

The Sunday Investor

Even though PFM has 373 constituents, it has roughly the same concentration in its top 20 industries as NOBL, which takes an equal-weight approach. In my view, choosing PFM over NOBL for diversification purposes doesn’t make sense. However, PFM appears to be a better choice for dividend growth and safety, as reflected by its “B+” grade compared to NOBL’s “B” grade.

Constituents also have a similar gross dividend yield of 2.09% but have stronger three- and five-year dividend growth rates. This more robust growth is anchored by stocks in the Data Processing & Outsourced Services, Systems Software, Managed Health Care, Semiconductors, and Health Care Equipment industries. Together, these account for 21.71% of PFM compared to 6.31% in NOBL.

Another positive feature is PFM’s lower dividend payout ratio (42.33% vs. 53.06%). I use 60% as a ballpark figure for what I consider safe (75% for Utilities), and only 13.99% of PFM’s constituents by weight cross this threshold. That figure increases to 23.42% for NOBL, so I think PFM has more room to grow their dividends, all things being equal.

Fundamental Analysis

For my fundamental analysis, I will look at each ETF’s revenue and earnings growth rates and their valuations. I’ve added SPYV to the mix due to its historical performance similarities.

Fundamental Snapshot By Industry - PFM vs. NOBL vs .SPYV, Data From Seeking Alpha

The Sunday Investor

The above table suggests that all three funds have similar revenue and earnings growth rates, though SPYV is cheaper than PFM based on its forward price-earnings ratio (21.08 vs. 21.70), trailing price-sales ratio (4.17 vs. 4.96), and trailing price-cash flow ratio (18.03 vs. 19.69). These differences are minor, but they suggest there’s no reason to be paying 0.53% per year in expenses for what appears to be an inferior portfolio.

Against NOBL, PFM does appear to have an edge. It has a larger market capitalization, which usually suggests better profitability, and it has better growth rates and valuations (except for price-sales). If you value dividend consistency, choose PFM, but this would not be my approach. Unless an ETF has much better fundamentals, I default to the lowest-cost option. SPYV’s expense ratio is only 0.04%, resulting in just 0.59% of your total gains lost to fees over ten years (assuming a 10% annual return). In contrast, according to Larry Bates’ calculator, you’ll lose 7.67% of your profits to fees with PFM.

T-Rex Score Calculator - How Much Is Lost In Fees

Larry Bates

Investment Recommendation

PFM certainly seems better than NOBL for those valuing dividend consistency. However, I caution against this approach, considering how PFM’s historical returns are nearly identical to SPYV. Its current portfolio is weaker on growth and valuation, and the 1.87% dividend yield is close to its lowest point ever and is unlikely a selling point for dividend investors.

The number of companies that have increased their payments for ten consecutive years is too large, and it’s no longer a metric that suggests superior quality. PFM is an average-at-best dividend ETF with high fees without any additional quality screens. I don’t recommend it and think you’re better off going with low-fee value ETFs instead.



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Alvopetro Energy Ltd (ALV) Q1 2022 Earnings Call Transcript

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Alvopetro Energy Ltd  ( TSX: ALV) Q1 2022 earnings call dated May. 13, 2022

Corporate Participants:

Corey C. Ruttan — President, Chief Executive Officer and Director

Alison Howard — Chief Financial Officer

Presentation:

Corey C. Ruttan — President, Chief Executive Officer and Director

Good morning. Thanks for joining us today for our Q1 2022 Results Webcast. I’m Corey Ruttan, President and CEO, and I’m joined by Alison Howard, our Chief Financial Officer.

As everyone knows, a replay of the webcast will be available on our website shortly after the call. All attendees are in listen-only mode for the duration of the webcast. Following the presentation, we will have a Q&A session using Zoom’s built-in Q&A feature. So if you’d like to ask a question, please click on the Q&A button on the bottom of your screen, and you can type in your questions at any time during the event. For those of you who are dialing in, you can also submit your questions by e-mail to social media at alvopetro.com.

So we’ll let everyone read the cautionary statements at their leisure. They’re also within our MD&A and our financial statements.

So just to start off, we continue to post pretty strong production results. I certainly think they’re well ahead of recommercialization expectations. We have our strongest quarter yet in the first quarter at 2,501 barrels of oil equivalent per day. That was up 15% year-over-year and up 3% quarter-over-quarter. April was a similarly strong month for us, just shy of 2,500 barrels of oil equivalent per day. So this is the same chart that we showed on our quarterly call last quarter. It shows the gas pricing mechanism within our gas sales agreement. The three gray dashed lines that you see here are the three different international benchmark prices that are used within our price calculation being Henry Hub, Brent oil equivalent and UK NBP gas prices. You can see the dark black line is Alvopetro’s calculated price. And you can see we had almost a 50% increase on the February 1 price redetermination. One of the other things you can see is because the Brazilian currency is appreciated since that redetermination happened, we’ve actually been above the contractual ceiling. So the ceiling is in green. It escalates based on US inflation. But because of that appreciation in the currency, you can see a gap here through the first quarter and it’s actually forecasted to continue based on our current foreign exchange forecast.

The other thing to note here is, to the left of the red dash line is the history and to the right of the red dash line is the forecast. So what we’ve done is we’ve updated this for the most recent strip pricing that we had for all three of those benchmark prices. We’ve then calculated what the price formula within our contracts fits out and that’s the blue line that you see here. But because of the ceiling, you can see the dark black line stays on the ceiling through the entire term of this graph here. So when you contrast that to what we showed two months ago — compared to the price forecast back two months ago, this period of time that we stay at the ceiling actually extends for two years longer. And if you compare it to the price forecast that were used by GLJ in our reserve evaluation, it actually extends it for a period of over three years longer than that forecast. And also, this gap between the blue line and the black line is bigger than what we showed last time. So what that tells you is this is kind of the amount that the combination of these three benchmark prices could decline by before we would actually realize a reduction in our gas sales price.

So with that, I’ll turn it over to Alison.

Alison Howard — Chief Financial Officer

Thanks, Corey, and good morning, everyone. So with those strong gas prices that Corey just referred to as of February 1, so two months in the first quarter, our operating netback increased significantly close over $17 per barrel of oil equivalent from Q4. So the operating netback is our operating profitability per unit of production and we use barrel of oil equivalent and we went to just under $54 which is the green bar that you see there in Q1 because of our realized sales price increased to $62 compared to $44 in Q4. So that’s a significant increase. And recall, this is only two months of production at that higher gas sales price. So should see an even further improvement in Q2 going forward when we have a full quarter at those higher prices.

Our production expenses, we’ve maintained below $4 since we came on production in July 2020. So those overall, most of our production expenses are fixed in nature. So we’re able to keep those costs low, and royalties have been consistent as well. So overall, very high operating netback margins, 87% being the highest one to-date here and overall since inception over 80%. I think it’s over 82%, actually, since inception. And on the royalty front, we talked about it in our MD&A, but we did get approval for a reduction in our government royalty rate effective May 1. So that should help improve our results going forward as well.

So then moving on with those strong operating netbacks, we have record funds flow from operations this quarter, increasing to $10.9 million, which is great, up $4.4 million from last quarter and that’s basically all due to that increase in our realized price because our production, we’ve been able to maintain close or right around this 2,500 barrels of oil equivalent per day, and that’s at the higher price and then a little bit lower G&A compared to Q4 was very strong funds flow from operations this quarter.

Similarly, net income increased as a result of those higher funds flow from operations. And then in addition, recall that we continue to be subject to foreign exchange fluctuations. And this quarter was a foreign exchange gain of $5 million compared to a loss of $0.9 million. So a swing of close to $6 million in our net income. Most of that is on our inter-company loan balances. I went into this a little bit last quarter. But for accounting purposes, we are required to recognize foreign exchange gains and losses on inter-company amounts, even though those limit the balances themselves or eliminated on consolidation. So we’ll continue to see fluctuations in net income for foreign exchange. But most of that, if you look at our statement of cash flow is adjusted in the statement of cash flows. So it’s all really mostly non-cash foreign exchange. And then those were significant increases in our net income and then with the increased funds flow and then that foreign exchange gain in the period, our deferred tax was higher this period, which caused a bit of a reduction. But overall, net income increased $8.5 million compared to last quarter. And again, record net income.

And then moving on with the strong cash flows and our continued strong production levels well ahead of expectations, our working capital, which is our current assets less current liabilities and shown in that green bar there has increased steadily since July 2020. And the orange line is our credit facility. And you can see starting in Q3 2021, our working capital actually started exceeding our credit facility balance and that gap has grown. And as of Q1, our working capital was $12.3 million and our credit facility balance of $5 million, so $7.3 million excess there. And with the strong cash positions and strong working capital, we did notify our lender that we would repay an additional $2.5 million as it’s effective next week. So that’s actually half of our balance that was outstanding at March 31 and it leaves us with an outstanding balance of $2.5 million and at these cash flow levels, that’s well under one month of cash flow.

Corey C. Ruttan — President, Chief Executive Officer and Director

Great. Thank you, Alison. So obviously, the record production and the higher gas prices made Q1 our strongest quarter to-date. Our funds flow from operations, as Alison highlighted, increased 68% quarter-over-quarter and 129% year-over-year, up to close to $11 million in the first quarter alone. You can see here on this graph, just kind of where we’ve been allocating our capital resources since we came on production. You can see during the first year of operations, we had a big chunk allocated towards repaying the credit facility, as Alison highlighted, relatively low amounts in yellow related to capital expenditures. Because of the strong results, we were able to start our dividend program about six months ahead of original plan starting in the third quarter. You can see that in the green wedges here, actually increased that this quarter by 33% up to $0.08 per share. And then in the first quarter of 2022, you can see us — the commencement of our 2022 capital program. So certainly, more allocation to that, and I’ll walk through kind of the early impacts of that.

To put this in perspective, the first seven quarters of production, so since July 5, we came on production from our Cabure project. You can see we’ve had funds flow from operations in excess of $43 million, close to a quarter of that’s gone to capital investments a little over a quarter of it to credit facility and interest payments and about 16% of that to dividends. So obviously, we’re very focused on our next phase of growth. To be clear, our near-term objective is to get to 18-plus million cubic feet a day. That would represent a 30% increase from where we are today. Our longer-term target is to double the size of our plant and be roughly 50% of the city gate that sits right at our gas plant location. The growth is planned to come from a combination of areas. So first of all, our gas plant expansion is on-track to add that capacity. We expect to be able to produce and sell at least 18 million cubic feet a day, starting the middle part of this year.

Our Cabure asset continues to perform very well. Along with our partner there, we do plan to drill one additional well targeting both some shallow development potential, but more importantly, some exciting exploration potential on the Western side of the fault, targeting the same reservoirs we’re producing from today. So that could further extend the productive capability of the Cabure field. And then we’ve got our 100% projects that we’re investing in our 2022 capital program. We just finished drilling the first of two conventional exploration wells and announced a success based on logs there at the 182-C1 location. The rig is now on the 183-B1 location and we should start drilling that shortly. As you recall, GLJ had independently assessed both of these prospects at 4.6 million and 5.9 million barrels of oil prospective resource, respectively, with 47% and 44% chances of success. Our plan here with the successes would be to tie these in directly to our gas plant directly to the South, so that it will involve building a new pipeline.

And then lastly, our Murucututu/Gomo project, it sits immediately North of our Cabure asset. I’ll walk you through what the capital plan looks like here. But we’re I think, well positioned to implement a broader scale our Gomo development plan and we’re very excited about our 2022 capital program. So just to talk about our 182-C1 results, so we reached a total depth here in April. This was a multi-zone prospect, so we were targeting the Agua Grande and Sergi formations. What we encountered you can see on the well logs here on the left is a very continuous, very thick 36-meter Agua Grande sand. About 25 meters of that you can see on the right-hand side, meets our net pay cutoff thresholds, but it is a nice fit continuous sand that we’ve got here. The well log show average water saturations of about 34% and average porosity of 8.2%.

One of the things that did happen is as we drilled through the Agua Grande almost immediately thereafter, we crossed over the main bounding fault on the Eastern side of the prospect and we ended up not encountering the Sergi formation, which was the second target in this well. What happens is after we get our well logs we go back and recalibrate our seismic and all the time depth relationships. And once you have a well result, you can much better correlate the individual seismic sequences and the seismic character to the actual reservoirs that you validate based on the log and we can also better image the fault. So what our plan here is to drill a follow-up location further to the East and it’s kind of multi-purpose. So the first objective is to help better define the lateral extent of our Agua Grande discovery. We don’t see any water lag or anything on the log. So we’ll need to drill further to the East to really test the limits of this, but it’s pretty exciting. The other thing that we think can happen because we’re very close to the fault, what can sometimes happen as you get these cementation effects that can occur close to the fault. So we think as we move further away from the fault to the East that we’ll get more typical Agua Grande porosity that we see in the analog fields all around us. And then the third objective, obviously, is we still expect to encounter the Sergi formation in that more Easterly location when we drill the follow-up well. So obviously, pretty exciting to drill our first exploration well and have a success here. We look forward to testing the well later this quarter.

So moving on to the 183-B1 location like I said, the rig is on location here now. This is another 100% working interest prospect. It sits immediately to the Northeast of the 182-C1 locations. So you can see the fault block that we drilled into for the 182-C1. This is the fault block immediately to the East that you see here and on trend with the analog Biriba. Again, it’s a multi-zone pre-rift prospect, targeting the same Agua Grande and Sergi sands. On the cross-section on the left here, you can see the prospective reservoir sand stacked up against basement on the other side of the bounding fault. Again, this was evaluated by GLJ at 5.9 million barrels of oil equivalent, best estimate prospective resource with a 44% transit discovery.

So moving on to our Gomo/Murucututu project again, the Cabure field sits within this blue outline here. This was our original pipeline from Cabure, flowing to the West to our gas plant location. We’ve completed the construction of the pipeline up to the 183-1 location and we’re in the final phases of constructing the service production battery and facilities. We expect to be able to have that well on production here later this quarter. Then the next step will be to complete the tie-in of the 197-1 well, stimulate that well and then tie that in. We are waiting on permits to do that, but we’re lined up to execute that plan very quickly or immediately after receipt of the permits. And then the next step will be to drill the first two fit-for-purpose Gomo development wells off of these pads. The 2022 capital program that you see here targets the development of our 2P reserves. So on the production chart here it’s the lower lightest green color, on the capital chart on the bottom right. It’s the capital that we’ve allocated in the reserve report in 2022.

We then have a multiyear development plan here targeting the contingent and prospective resource that sits to the North. And you can see on an unrisked best estimate basis with success here, this asset alone has the potential of contributing up to 20 million cubic feet a day for us. So we’re pretty excited about having all this infrastructure in place and starting to drill wells here later this year as well.

Just to put this on again chart to give you a sense, the 182-C1 prospect, obviously, drilled, test that later this quarter. The 183-B1 location we’re getting ready to drill that right away. We’ll then move the rig back to the 182-C1 location to drill the follow-up well. During that same period of time, we expect our joint unit well to be drilled with our partner here. On the Murucututu project, like I said, we’re very close to having a 183-1 well tied in. And then subject to permitting, the rest of this activity that I talked about will follow through the rest of this year because that’s all pipeline connected, we can bring this production on relatively quickly. You can see that highlighted by the green flames here because we have a pipeline to build for the two exploration prospects, the production as actually wouldn’t come until 2023. And then the last part of this is just our gas plant expansion is on track for the middle part of this year, where we’ll have capacity of at least 18 million cubic feet a day available to us.

So just in summary, we continue to think Alvopetro offers an attractive investment proposition, no matter what your investing focus is. I think we’ve highlighted that we’re continuing to deliver results well ahead of expectations. Q1 was obviously a new record for production and cash flow for us. Our gas prices are obviously very attractive but Alison also walked through our operating netback margins. Those are industry-leading margins up to 87% in the first quarter. Our balance sheet continues to get even stronger. We’re almost debt-free and certainly on a net cash position in an extremely good position. That helps underpin our balanced kind of reinvestment and stakeholder return model that we’ve talked about for some time, where going forward, we’re looking to basically allocate half of our cash flows to organic growth and half of our cash flows in returns to stakeholders.

If you look at it from a value perspective, we’re trading at less than half of our 2P asset value and that’s before considering our most recent exploration success and any of the potential associated with that 2022 capital program that we reviewed. We’re also trading at about 3 times annualized funds flow from operations. So certainly, I think that we’re extremely attractively valued right now for yield investors, obviously, delivering a dividend yield over 7.5%, paying dividends quarterly paid in US dollars. And then for growth investors, obviously, I think we’ve got a very exciting 2022 capital program, significant near-term catalysts, especially when you consider the potential value relative to our current market capitalization.

So with that, I think we’re ready for the question-and-answer period. Before we get into that, just a reminder for those on the webcast, you can submit your question by hitting the Q&A button within Zoom.

Questions and Answers:

Alison Howard — Chief Financial Officer

Okay. Great. I’ll start with a few questions. Maybe we’ll start with the 182-C1 well, which was the well that we just drilled. Were the law calculations and net pay on 182-C1 comparable to other wells producing in that formation.

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. So the thickness was actually probably at the very high end of the range that we would have expected. I would say the porosity is certainly lower than what we expected, but still, especially for gas within a good range and I think on a combined basis, certainly within our range of expectations for the Agua Grande. And I think like I highlighted, we still expect to also encounter the Sergi. Just to reiterate, I do think as we move further east from the fault that we’re going to get the more typical Agua Grande porosity that’s seen in the analogous pools to the northeast and northwest of us.

Alison Howard — Chief Financial Officer

And when do you anticipate completion work on 182-C1 to begin?

Corey C. Ruttan — President, Chief Executive Officer and Director

So we’re just in the final phases of contracting, but we do expect to have that work done later this quarter.

Alison Howard — Chief Financial Officer

Is it possible to use the 182-C1 well as a producer or do you need to drill development wells before bringing this field on production?

Corey C. Ruttan — President, Chief Executive Officer and Director

Well, we need to test it first. But yes, no, it can be a producer because we have a pipeline, that project between permitting and constructions is roughly a year between now and when the pipeline is committed or completed, we can drill a follow-up delineation and development wells and bring on hopefully a chunky production base, but step one, we need to test the well.

Alison Howard — Chief Financial Officer

And is the follow-up well on Block 182 an appraisal or is there another interval you’re now chasing?

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. So again, just to kind of reiterate what we’ve reviewed on that slide is it’s kind of — we’re drilling that for three reasons. Because we’ve got what looks like gas saturation from top to bottom, which is fantastic, it doesn’t really constrain the limits of what we see there. So to really understand how big the Agua Grande formation could be, we have to drill further to the east and further down depth to see how far away the hydrocarbon column actually extend. So that’s the first objective.

The second objective is to target the better porosity that we would normally see in the Agua Grande as we move further away from the fault. And then the third objective, which gets to your question is, yes, we absolutely still expect to encounter the Sergi formation and that’s why we need to drill further to these because we crossed the fault right below the Agua Grande formation. If we just move over, we’ll encounter the Sergi sands on the eastern side of the fault.

Alison Howard — Chief Financial Officer

And has the success at 182-C1 derisks the chance of success at your second exploration well on Block 183, which is our 183-B1 well?

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. Certainly, I feel great about it. But I think technically, they’re all independent prospects. Part of the reason GLJ assigned 44% and 47% chance of success in this area is we do have analog tools that show that these faults have good ceiling capacity. We talked about that before we drilled the well. I think this just adds one more data point to prove that these faults have good sealing capacity. But technically, it’s a different fault. It’s very close, but technically still has those typical type of exploration risk associated with it.

Alison Howard — Chief Financial Officer

And can you review your drilling plants after 183-B1?

Corey C. Ruttan — President, Chief Executive Officer and Director

So yeah, we might have answered a couple of these questions as we went through, but I think this slide does a good job of walking through the catalyst and the drilling timing. Obviously, these things are always a little bit in flux and the Murucututu program, in particular here, we do have some permits that we think are in the final phases of getting, but the timing or sequencing is drilling the 183-B1 well next, the rigs on location, go back to the 182-C1 pad and drill the follow-up well, which is we’re calling 182-C2. So that’s the well to follow-up on the recent exploration success in the Eastern location. We then moved that rig to our Murucututu project, drilled the first of two development wells, fit-for-purpose development wells into our Gomo Murucututu asset here. The unit well will be drilled with a different rigs, will be happening in parallel with this other activity is our expectation.

Alison Howard — Chief Financial Officer

Okay. So switching gears a little bit, how is the upgrade to the gas processing facility coming along? Is it coming in on time?

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. I think within seven to 10 days of expectation, it’s roughly on-time. So we’ll have some commissioning work. So we’re preparing the production facilities in May here for receivable of vessels that will be received later in June, so that we’ll be able to very quickly tie those in and turn the extra capacity on in July. There will be a short commissioning period at that time as well, but we expect a pretty quick ramp-up right up to the 18-plus million cubic feet a day of capacity.

Alison Howard — Chief Financial Officer

And is the 183-1 well on Murucututu tied into the pipeline and producing?

Corey C. Ruttan — President, Chief Executive Officer and Director

So the 183-1 well is tied in, that pipeline is complete. We’re just in the final phases of the production facility being constructed. So that’s the last step. Once that’s done, we’re ready to turn the well on production. So we expect to have that to happen here by the end of this quarter.

Alison Howard — Chief Financial Officer

Okay. And then shifting to some more —

Corey C. Ruttan — President, Chief Executive Officer and Director

Sorry, maybe just one other point to make here. The MURS-1 location that we have located here, this location would actually be drilled off that same service production lease. So when we drill that, it would be immediately tied into the EPF. The 197-1 well involves stimulating the well and building another roughly two kilometer pipeline. Once that’s done, that pipeline route is right on the MURS-1 location. So that’s why all of these we’re expecting to be able to — when we complete the capital activity fairly quickly turn them on production.

Alison Howard — Chief Financial Officer

Okay. And then maybe switching to some financial-related questions. Production expense per BOE increased a bit versus the previous quarter. What are the causes behind the increase? And what are your expectations for future quarters? I can take that one if it’s good.

Yeah. Our production expenses did increase marginally compared to Q1 2021 and Q4 2021. Part of that is most of our costs are fixed in nature, but with respect to our share of production costs from the unit, where we have a 49% working interest that’s based on our share of production allocations and we actually took 100% of the gas production from the unit in Q1 2022 compared to only 81% in Q1 2021. So that’s part of it. We do pay some additional fees right now for capacity above the nameplate processing capacity at the UPGN. When we complete this facility expansion that Enerflex is working on right now, that will shift to a capital lease, so it will actually come out of our operating expense. But that’s part of the reason for the increase as well.

And then lastly, the foreign exchange rates, the Brazil currency the reais improved on average relative to both Q4 and Q1, about 6% and 5%, respectively. So that causes our US dollar equivalent prices to go up a little bit. Going forward, I think we’re still targeting to be in that $4 per BOE range at these production levels will be impacted a little bit by foreign exchange, obviously, and then whether or not our partner takes their share of the gas. But overall, that’s our target is $4 going forward. And again, reiterating on our netback, this was only two months at this higher price. So we are expecting to see an improvement in our netback in Q2, for example, potentially over $60 per BOE in our netbacks just with two months at this higher price, assuming we’ll keep these production costs where they are and with that royalty amendment we discussed previously, which is actually the next question was asking about the royalty rates and —

Corey C. Ruttan — President, Chief Executive Officer and Director

But just to be clear, sorry, we’re talking about a $0.16 or $0.17 increase?

Alison Howard — Chief Financial Officer

Yeah, still very low. But yes, a marginal increase, but still very low. And then, yes, again, our royalty, we did get that royalty amendment. That was another question, we do have that effective for me production going forward.

Sorry, just let me give me one second here. With debt almost repaid free cash flow rising and the dividend already increased sharply, when will the Board start to consider a share repurchase program?

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. So I guess the way we look at this, like I said, our plan, we’ve talked about this for a long time. I think there’s a lot of companies out there doing it now. But before we even came on production, we said, look, take roughly half of our cash flows, reinvest that in organic growth, the other half to stakeholders. And obviously, I pointed out, our first priority was to repay the project financing loan. That’s almost complete. So I think once that’s complete, it sets a stage more for that discussion. So obviously, the bucket that’s allocated to stakeholders, with the debt stakeholder gone, the biggest stakeholder remaining is our shareholders. And then how we allocate that capital to shareholders, whether it’s dividends or buybacks, that’s a decision the Board will have to make in coming quarters. So we’re certainly not committing to that, but it’s obviously another tool in the tool kit that we can use to deliver returns to stakeholders.

Alison Howard — Chief Financial Officer

Another question here. What are your expectations with regards to cash tax payments this year?

I’ll take that one, yeah. Obviously, our cash tax is very low, consistent with Q4, but we had a large increase in our funds flow from operations. And that’s due to — we are eligible for the SUDENE benefit in Brazil. And then in addition, exploration costs are deductible and computing current tax, so that we benefit from a lower current tax. We don’t provide guidance, but overall, we are expecting current tax to increase in the future, but still be very low, I think, relative to most jurisdictions with the benefit of the SUDENE 15% tax rate that we benefit from right now. And obviously, we have tax pools, etc. So we’re always managing that to keep our current tax as low as possible. But yeah, we do expect that there will be — we will see a bit of an increase later this year and into next year.

The next question is what is the impact on cost inflation globally and service availability in terms of your exploration and development plans?

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. So I think one of the things about operating internationally is we’ve always had to manage projects with reasonably long durations, good planning. Obviously, those are keys to success. Things like you’re hearing this everywhere like tubulars for drilling wells, etc, the lead times are certainly longer and those are just things that we have on our [Indecipherable] chart probably earlier than we might have otherwise. But I think we’re well equipped to adapt to those things. We are seeing some certainly cost inflation and inflation in Brazil is above 10%, so that will get reflected in kind of the overall labor environment in Brazil. We obviously have a foreign currency effect that impacts that as well.

Alison Howard — Chief Financial Officer

And then what are your views on the state of the energy M&A market in Brazil?

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. So far, the energy M&A market has been dominated by Petrobras divesting of it virtually its entire onshore upstream inventory of assets. They’ve been in very large clusters that was recently announced one of the other and final cluster within our basin. Just looks like it’s in the process of being sold for $1.4 billion. So the good news is the industry is opening up. Petrobras’ influence on our sector is continuing to reduce. And I think longer term, that’s going to continue to open the door for more of that type of activity. Obviously, for us, if we can add shareholder value organically from the capital that we’re spending this year and leverage off the strategic infrastructure that we’ve got in place, we can add a lot of value for shareholders with success there.

Alison Howard — Chief Financial Officer

Just going back to 182-C1 and the discovery there. What is the length of that pipeline to connect to your existing gas processing facility and do you have any estimates of cost?

Corey C. Ruttan — President, Chief Executive Officer and Director

From the 182-C1?

Alison Howard — Chief Financial Officer

Yes.

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. So it will depend that happens with 183-B1 as well. If we go all the way to that location, it’s closer to 15 kilometers, it’s about 13 kilometers from the existing discovery that we’ve got. The answer to the capital cost will depend on how big the diameter of the pipeline is. But if we use kind of our Cabure experience, it’s in the probably — on the bigger end of the expectations for pipeline diameter, it’s probably closer to $4 million to $5 million.

Alison Howard — Chief Financial Officer

And I think our last question is how open is the gas utility to buy more gas from Alvopetro, i.e., past 18 million cubic feet a day?

Corey C. Ruttan — President, Chief Executive Officer and Director

Yeah. From everything they’ve told us, they would be pleased to take as much gas as possible. Like keep in mind, the marginal gas molecule that’s being consumed in Brazil has to be imported with LNG. And you saw the NBP prices, which is maybe a bit of a proxy for LNG, but landed LNG prices are probably double what our price is. So there’s a high amount of interest in us increasing our production.

Alison Howard — Chief Financial Officer

And there are no further questions at this time.

Corey C. Ruttan — President, Chief Executive Officer and Director

All right. Well, a very exciting quarter for us. Thank you to everyone for joining and look forward to updating you in three months’ time. If you have questions in the meantime, don’t hesitate calling Alison or myself and thank you again for all your support.

Alison Howard — Chief Financial Officer

Yes. Thanks everyone.



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