Good day ladies and gentlemen, and welcome to the Pegasystems' Second Quarter 2020 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ken Stillwell. Please go ahead.

Thank you. Good evening ladies and gentlemen and welcome to Pegasystems' Q2 2020 earnings call. Before we begin, I would like to read our Safe Harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995. The words expect, anticipate, intend, plan, believe, will, could, should, estimate, may, target, strategy, intends to, projects, forecasts, guidance, likely and usually, or variations of such words or other similar expressions, identify forward-looking statements, which speak only as of the date that this statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2020 and beyond could differ materially from the company's current expectations. Factors that could cause the company's results to differ materially from those expressed in forward-looking statements are contained in the company's press release announcing its Q2 2020 earnings and in the company's filing with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the year ended December 31, 2019 and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements and there are no assurances that the matters contained in such statements will be achieved. Although subsequent events may cause our view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise the forward-looking statements, whether as a result of new information, future events, or otherwise. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Ken. Let me say that I'm pleased with our results for the first half, especially given the global pandemic. We are operating at a time of uncertainty and anxiety. I'm deeply respectful of how our team and our clients are engaging constructively and optimistically, despite the many tensions. All results reaffirm what we said last quarter, about how we thought the pandemic would likely to affect us and our clients in the near term. Our expectation that digital transformation would remain front and center, even during COVID has held true in Q2. Our business remains robust and we're helped by several major factors. An increasing percentage of our revenue is predictable and recurring. In the first half, our total annual contract value, which we consider the best indicator of our improving cash flows and underlying business growth increased by 21% year-over-year. Over 90% of our new clients are predictable. Our Pega Cloud business continues to grow above 50% year-over-year. We are fortunate that digital transformation is more important than ever, and our strategy is resonating with our clients' prospects. Most of our clients are in industries that are less adversely affected by the pandemic, such as financial services, insurance, healthcare, government, and telecommunications, rather than being heavily impacted in areas like hospitality, travel, and consumer products. Our clients tend to be large organizations that can withstand the short-term financial pressures of today's market. We have little exposure comparatively to smaller organizations that are unfortunately struggling the most right now. And we have a very strong cash position with more than $0.5 billion in liquidity to help us weather this storm and continue to invest where it makes sense for long-term growth. We have a strong and resilient team that is committed to the success of our clients. As I said last year, we've navigated many challenging times in our history, and we've always come out stronger on the other end. Now in terms of our response to the pandemic, based on what we see today, digital transformation is on everyone's mind. Whether modernizing the customer experience or building the automated connective tissue through operations itself, we've seen some opportunities put on hold, but other projects have accelerated and new ones have been initiated. The types of challenges our clients face a few months ago continue, in some cases, to accelerate. For example, needs like managing avalanches of customer service inquiries, supporting remote workforces, or adjusting to new government policies are all well supported by our technology. While we assist them in the immediate term, we also see their desire to build stronger businesses for a new future. The solutions we introduced early in the pandemic have been well received and continue to open doors for us. We continue to improve our software to make it easier for clients to enhance customer engagement, boost employee satisfaction, improve their efficiency, and reduce costs. For example, since we last spoke, we launched a number of interesting new capabilities. The first was an Ethical Bias Check, a new capability in the Pega customer decision hub that helps eliminate biases hidden in the artificial intelligence driving customer engagement. We talked about the Pega process traveler, a new cloud-based software architecture, designed to radically streamline organizations to drive work across distributed enterprises, breaking down technology silos, to unify what exists across the enterprise and help improve user experience. We introduced the Pega customer service unified messaging division, a new SaaS-based application that helps customer service teams respond faster and more efficiently to customers reaching out across different channels, allowing them to do it through a single unified dashboard. Most recently, we introduced a really exciting capability called X-ray vision, the industry's first self-healing robotic process automation capability, able to detect and fix broken bots without human intervention, enabling clients to operate faster and more durably, and facilitating easier deployment of robotic process automation. Our products continue to receive strong industry analyst attention. Since we last spoke, Gartner recognized us in their Magic Quadrant for the CRM customer engagement center and the Magic Quadrant for multi-channel marketing hubs. Moving to new business, our new business is particularly strong in traditional areas such as financial services, government, healthcare, and insurance—the industries where Pega really grew up. I indicated that we expected these to be more resilient during the pandemic, and that has turned out to be the case. For example, in healthcare, one of the largest U.S. healthcare payers recently merged with a leading pharmacy benefit manager. They're using Pega to bridge their multiple customer service environments to drive service standards at the corporate level. They expect to significantly reduce operational costs while maximizing the value of the first operation through their customer base. In financial services, a large institution serving a customer base in the tens of millions is expanding its use of Pega, leveraging our AI-based customer decision hub in the cloud to provide customers with a one-to-one personalized experience across the entire enterprise and multiple channels. The goal is to transform currently disconnected experiences into cohesive, personalized conversations, to improve consistency, accelerate time to market, and deliver ongoing value. It's all about creating exceptional customer service. There's also been a lot of traction in the government sector globally. For example, Her Majesty's Revenue & Customs, akin to their IRS, have expanded their use of Pega, transforming the desktop experience for their 30,000 telephone advisors who are expected to handle about 45 million calls this year. Running on Pega Cloud, we're transitioning from a legacy of inefficient multiple desktop applications to an efficient solution that reduces handling time and post-call wrap-up and will lead to a better experience for employees and taxpayers alike, all while driving huge savings. The new application is already live and being rolled out across the organization to terrific reviews. Now, the IRS, the U.S. counterpart of HMRC, one that I mentioned we had just won in the last quarter, announced just last week a new enterprise digitalization and case management office. This new organization has been created to spearhead their efforts to empower both taxpayers and IRS employees to rapidly resolve issues in a simplified digital environment. The IRS has outlined their goal to consolidate the case management system to overcome the challenges of managing casework across 60 plus aging systems, most of which do not communicate effectively. They also noted that the first release utilizing Pega is already well underway. Last quarter, I mentioned the state of Bavaria, Germany, chose Pega to help them provide faster relief to small and medium-sized businesses affected by COVID. This was a great example of how we're able to sell, develop, and launch applications in record time, even when working remotely. Based on the success of that initiative, our software last quarter was chosen for a much larger project for the German Federal Government to support a new bridging aid program that will replace previous government programs. The new application will be used across all 16 states in the country. These projects are great examples of how flexible our technology is. We can deliver hyper-quickly and be used for serious large-scale transformations. As I mentioned last quarter, we pivoted quickly to operate as nearly a 100% remote workforce and have been doing so effectively since March. As you can see from our results, this new working situation has not significantly impacted our ability to sell and serve our clients. In many cases, we're seeing unprecedented access to senior client executives and can coordinate meetings much faster compared to the old days when getting everyone in the same place was a hassle. We've demonstrated that we can effectively onboard new employees while being completely remote, so we're continuing to hire more selectively and strategically. Since we last spoke, we held Pega World virtually and it involved a complete reimagination of that event. We weren't quite sure what to expect, and we were frankly blown away by the results. We had more than 42,000 people register. This compares to a little over 6,000 that we might have gotten in in-person events. More than 26,000 attended, which is outstanding for a free virtual event, where the industry standard is about a 25% conversion rate, whereas we saw over 60%. We also observed significant engagement growth, as we set a record for page views on pega.com during April, May, and June and answered more than 1,300 questions through live Q&A during the event. We continue to draw large audiences to our archived presentations and received lots of positive feedback on the format and content, which clearly indicates that we made the right decision to create an event tailored to a digital experience rather than merely replicating an in-person event online like a large webinar. In case you didn't attend, we'd love to hear your feedback—it's all available online, and we're converting all of our second-half events to virtual formats while deepening our understanding of what those events should look like, incorporating lessons learned from the first half. We continue to believe that for our partners and clients, there will be no return to business as usual. In our work with clients and prospects, we see that digital transformation initiatives are of great importance. I personally believe we still have some time to go before we reach any kind of somewhat predictable normal. In the meantime, we are well positioned to help our clients adjust to uncertainty while planning for their long-term success. We are confident that we will achieve much more than disadvantageous cost prices and come out a stronger company in the long term. We are deeply gratified by the continued high level of support from our staff, clients, and partners. It's truly during times like this that we can see strong character in those we work with, and we are committed to continue to support the larger Pega community and those around us who are facing the very real challenges that have arisen as a result of this crisis. In summary, I'm pleased with our first-half results, especially in light of the global crisis, and to provide more color on the financial results, I am turning you over to our CFO, Ken Stillwell. Ken, the floor is yours.

Thanks, Alan. I want to express my best wishes for everyone's safety and well-being during this unprecedented time. I'm going to start my remarks today by sharing some insights on Kevin's response to COVID-19 and a few observations on the impact of the pandemic on our clients, our employees, and our industry. Starting with our customers. To date, the overwhelming majority of our clients and prospects' digital transformation buying behavior has been largely unaffected by the pandemic. While our business has not been negatively impacted in a significant way, we did see a couple of projects delayed or canceled due to shifting priorities of some client organizations. We also saw a small number of our clients request additional flexibility with extended payment terms to help them navigate this downturn. Most of our clients and prospects are acting with a new sense of urgency, rethinking what they should do differently in the short term and long term to build a robust modern business architecture. As a result, in many cases, our sales teams have gained more access to senior level executives than ever before, enabling very effective discussions that were previously difficult to coordinate due to travel schedules and a historical bias towards face-to-face meetings. The good news for us is that this increased level of executive engagement and solid execution by our sales and marketing teams resulted in a strong Q2, especially given the environment we're in—these results are exciting to see. Clearly, many leaders are prioritizing digital transformation projects in a new way, given the structural changes in how people are working remotely and interacting through digital channels. We continue to be optimistic about our ability to accelerate growth, fueled by the increased urgency surrounding digital transformation. Our employees have done an incredible job transitioning to remote work. They have been working diligently with our partners and clients and continuing to execute our strategy. It has been somewhat amazing to see how well our employees worldwide have adjusted to this new work environment, and as Alan mentioned, I don't think things will return to the way they were. There's a lot of positivity in that. Our field teams have successfully engaged with customers and closed deals virtually and digitally. Only time will tell, but the performance we saw in Q2 may represent the spark of a new era in enterprise software selling. Even after this situation subsides, we will continue to see a mix of virtual and in-person sales activity. In regard to our employees, we are focused on supporting them to be as productive as possible in remote work settings, and we're continuously evaluating the safest, most efficient means to provide our employees access to physical offices when appropriate. Next, I want to share some thoughts on the pandemic's impact on our industry. The enterprise software industry is currently experiencing significant disruption. Over the last decade, the rise of subscription software has reshaped our field. In the first half of 2020, we observed clear indications that this pandemic will accelerate the adoption of subscription software, driven by the uptick in remote work and the rapid pace of digital transformation. During our last earnings call, I reiterated the resilience of our business and remain confident in our capability to deliver on our long-term strategy to be a leader in digital transformation. To remind you why I feel this way, first, we have been transitioning our business from a largely perpetual software license model to a recurring license model for several years. In the first half, more than 90% of our software revenue came from recurring sources, demonstrated by our high net retention rate. Additionally, the growth rate of our subscription revenue accelerated in Q2. We continue to move away from professional services as a primary revenue contributor, engaging more of our partners to support our clients' implementation and value realization efforts. The shift to recurring revenue is especially significant in times like these; it allows our quarterly revenue and billings to be much less vulnerable to short-term disruptions such as the current situation. A business with a higher proportion of recurring revenue and lower customer churn rates, like Pega, is less reliant on new business bookings to reach revenue and billing goals. Secondly, the key verticals we serve—financial services, insurance, healthcare, communications, and government—are less exposed to the direct impacts of the pandemic than sectors like airline, hotels, restaurants, and retail. Many of these clients, even those from challenging industries, recognize the critical need for digital transformation. In Q2, we observed solid demand from clients across various sectors; in fact, financial services, insurance, healthcare, and government accounted for approximately 80% of our new license bookings for the quarter. Moreover, our existing and target clients are among the world's largest organizations; many of these Global 3000 enterprises are better equipped to handle downturns compared to small and medium-sized businesses, which often struggle the most. The foundational strength of our large enterprise customer base is a core asset that has enabled us not only to weather difficult economic periods in the past but also to grow our revenue during those times. Our large clients, particularly in North America, were significant contributors to our Q2 growth. Lastly, we have the liquidity required to navigate through this crisis. Earlier this year, we raised over $500 million through a convertible debt offering. As I mentioned before, whether by good fortune or wise planning, February was an ideal time to acquire this capital. This liquidity positions us with the financial strength and flexibility needed to navigate the digital transformation market effectively and to make sound long-term decisions. Finally, our digital transformation solutions are mission-critical for our customers. Our customer engagement suite empowers clients to retain customers, while our intelligent automation suite—including our industry-leading business process management software—enables businesses to reduce costs through improved efficiency and effectiveness. Our digital transformation solutions are particularly relevant in times like these; businesses with robust digital infrastructure have swiftly adapted their operations to support remote workforces and operations. Now let's move on to our financial results for the first half of 2020, particularly for those who are new to Pega. I will first provide context regarding the evolution of our business model. During our cloud transition, the two most important metrics we track for strategical execution are annual contract value (ACV) and remaining performance obligations (RPO)—the latter is also known as our backlog. I will start by discussing ACV. Total ACV is the sum of recurring Pega Cloud and client cloud commitments, representing the annualized spend from our clients for cloud licensing and maintenance. Increasing ACV is critical as it serves as the best leading indicator of our future revenue. I'm pleased to report that our ACV increased year-over-year by 21% on a constant currency basis. At the end of Q2, our total ACV was $738 million, up from $611 million at the end of Q2 2019, marking a remarkable increase of $127 million. The majority of our ACV increase was driven by Pega Cloud, which grew by 66% from $135 million a year ago to $211 million in Q2 of this year, in constant currency. It is exciting to see the Pega Cloud segment of our business exceed $200 million in ACV for the first time in our history, nearly doubling in size in just about 18 months. Client cloud likewise increased by 11% from June 30, 2019. Overall, ACV remains our most crucial metric, reflecting the successful execution of our strategy, and while a 21% increase demonstrates strong growth, we believe there are opportunities to further accelerate this growth in the future. We are investing in go-to-market resources to capture an increasing share of our clients' spending on digital transformation. Next, let's discuss remaining performance obligations or backlog, which provides visibility into the revenue that will be recognized in the upcoming periods. A robust backlog is another advantage of our cloud transition. Historically, bookings were recorded as immediate revenue in the current period, which caused variability in our quarterly results. These days, the largest portion of our bookings are cloud-based, most of which goes into backlog, creating a more predictable revenue and cash flow stream going forward. Pega Cloud backlog grew 26% from $362 million as of June 30, 2019, to $457 million as of June 30, 2020. Total backlog increased by 30% from $628 million in June of last year to $817 million at the end of Q2 2020, which is particularly impressive given that our backlog typically grows at a slower rate during the middle of our financial year due to a higher concentration of business activity that usually occurs in the fourth quarter for enterprise software companies. Regarding revenue, total revenue for the first half of 2020 was $493 million, an 18% increase from total revenue in the same period last year, primarily driven by a 55% increase in Pega Cloud revenue. As we continue our cloud transition, understanding the impact of this shift on revenue growth is crucial. We have been moving away from professional license bookings, replacing large upfront cash and revenue with cash and revenue that will be received and recognized over many years. Therefore, during the first half of our cloud transition, revenue growth acted as a lagging indicator, as subscription revenue is recognized over time versus perpetual license revenue, which is recognized immediately. Given this dynamic, we focused on ACV growth as that has become the leading indicator of successful strategic execution. Now that we have passed the midpoint of our cloud transition, revenue and ACV growth have begun to converge and we expect this convergence to continue over the remaining two years of our transition. For the first half of the year, our success in closing new and expanding Pega Cloud and client cloud deals has driven our growth in term license and maintenance revenue, which makes up our recurring revenue sources. Total subscription revenue for the first half of 2020 increased by 38% year-over-year, surging from $270 million to $373 million—an increase of $103 million. Professional services revenue declined by nearly 6% or just under $7 million for the first half of 2020 compared to the first half of 2019. It's worth noting that the majority of this decline, nearly all of it, is attributable to reduced billable expenses for travel, as our service teams executed project work remotely. Additionally, a few of our professional services engagements were not viable when managed remotely, which impacted our professional services revenue. In the first half of 2020, Pega Cloud comprised about half of our new client commitments, aligning with our expectations. Overall, over 90% of our new client commitments were comprised of either Pega Cloud or client cloud, while the remaining portions were perpetual license agreements. For the three months ended June 30, 2020, we reported both GAAP and non-GAAP results, and a full reconciliation of all GAAP and non-GAAP measures is provided in the financial tables of the press release issued earlier today, which are also available in the Investor Relations section of our website. Non-GAAP net loss was $0.28 per share, compared to a net loss of $0.30 per share a year ago, indicating that revenue performance will continue to improve as we exit the cloud transition in the coming years. We remain very confident that the long-term benefits of a recurring business model—including a more predictable future revenue and cash flow stream—greatly outweigh the short-term adjustments to reported revenue and the effects on near-term cash flow and reported EPS. Let's cover a few additional details. You may recall that we had a successful convertible offering in the first quarter. Pega finished the second quarter with total cash and marketable securities of $512 million as of June 30, 2020, down from $538 million at the end of the first quarter. During the first half of the year, we returned about $48 million to shareholders through dividends, buybacks, and net settlements in equity. We ended the quarter with over 5,500 employees worldwide, an increase of around 13% from one year prior. We are disappointed that we couldn't provide a strategy upgrade during Pega World. However, we have decided to hold an investor briefing on Tuesday, August 25, which will also be virtual, and it aims to update on the progress of our transition towards an as-a-service business model. If you're interested in joining that session, please reach out to [email protected]. In conclusion, being at the midpoint of the year, we are very pleased with our business's performance. As we look ahead, we acknowledge the increased uncertainty in the current environment and the obstacles we face. However, we believe Pega remains well-positioned to deliver on our strategy to be the leader in digital transformation. With that, operator, we are ready to take questions.

Thank you. We’ll take our first question from Rishi Jaluria with D.A. Davidson. Please go ahead.

Hi, guys. Thanks so much for taking my questions and congratulations on the continued strength in the business. What are the updates on some of the hiring plans, especially regarding new sales reps? Alongside that on the sales rep side, how have you been feeling now in terms of sales coverage and general outlook?

I can answer that question. You blanked out a little bit. But if I understand you correctly, you're asking how we're feeling about the sales reps and their tenure and what we're hiring. I think the increased sales force has been able to do two things. One, it has given us greater reliability, which proved to be extremely helpful during this pandemic, because you have a lot more counter engagement, rather than just trying to bounce off customers without having enough reps to cover them fully. Additionally, I believe we've demonstrated that we've been able to grow as a result of hiring new sales reps. What I'm particularly pleased about is that I believe our onboarding and education processes have moved very effectively to this remote environment for our sales teams and for the other individuals we are hiring. So I anticipate continuing to improve productivity and effectiveness as we grow the sales force.

That's helpful. I wanted to get a sense of the strong ACV growth you've achieved thus far this year. Are there any indications from customers that there have been shifts in projects or IT initiatives postponed into the second half of this year? Or does the pipeline growth look strong so far in the second half of the year?

I'm not observing much evidence that people are sacrificing their second half for the first half. In fact, I see more clients canceling things they don't consider critical throughout the year to maintain their focus on what is critical. Thankfully, the digital transformations we facilitate generally fall into the critical category, addressing immediate needs while providing clients with a pathway to an architecturally sound and effective long-term solution. Thus, I have no compelling evidence to suggest that our second half will be problematic.

Lastly from me, could you elaborate on the mention that some services cannot be executed remotely? What specific challenges are causing that, and how does it impact our ability to deliver on closed deals? Are they simply causing delays until live deployments?

Sure, Rishi. It is exceptionally rare that we encounter a client unable to support our remote professional services work. I mentioned it because full disclosure requires me to acknowledge that it does happen from time to time, but it is not common and certainly not a significant issue. I'm genuinely surprised by how effectively people have adapted to working remotely. So while it does occur, it is not something that happens often. Many of these clients who have challenges supporting remote work are often among those who are most in need of digital transformation.

That's a good question. It's not solely us; the clients involved in these projects must also be comfortable working remotely. However, as Ken stated, this isn't a material aspect of our business.

We'll take our next question from Chris Merwin with Goldman Sachs. Please go ahead.

I wanted to inquire about the use cases for your products, the deals you are winning, or even those in the pipeline. Are you beginning to observe different use cases for the low-code platform, particularly in light of how many customers seem to be looking to digitally transform key systems where impetus might not have existed previously? I'm curious if you've noticed any recent evolutions in that area.

The encouraging evolution we're witnessing is that many organizations are realizing they have problems they didn’t previously recognize as issues. We're able to engage in more strategic conversations with senior leaders about developing a digital transformation strategy. Historically, there may have been less of a strategic focus, but by promoting low-code solutions that facilitate rapid delivery and strategic engagement, we're positioned advantageously. Our offering—spanning customer engagement, expert systems, and artificial intelligence to assist in decision-making—provides process automation to drive action and facilitates work across channels and back-end systems—this is a strong formula for any organization aiming to transform.

That's great to hear. And just one other question, Ken. I noticed that the backlog actually accelerated from 20% growth last quarter to 30% growth this quarter. Can you elaborate on what led to this significant uptick and provide any additional context regarding the cadence and bookings as you progressed through Q2?

Yes, Chris. A couple of interesting observations. The first is that as we hire more account executives and gain traction with our clients around faster sales cycles for Pega Cloud—it seems we are reducing client deployment cycles after achieving initial engagement with a minimal viable product. What we're witnessing is increased business activity throughout the year, contrasting with the historically large deals that accumulate at the end of the fourth quarter. As a result, this Q2 was by far the strongest we have experienced. While one would expect continued growth, it is especially notable given COVID-19, indicating healthy demand and execution. The second point to note is that the durability of contract lengths is holding steady, which signals that clients are thinking about their investments in Pega on a long-term basis. We're not encouraging our sales teams to elongate contracts artificially; rather, we see the heightened business activity alongside steady contract durations, particularly around Pega Cloud. This is an encouraging sign of our retention rates, the ongoing investment in us, and the momentum of Pega Cloud.

We'll take our next question from Steve Enders with KeyBanc. Please go ahead.

I wanted to check on the pipeline, which was reported as considerably stronger year-over-year last quarter, to get a sense of its current status. How has the top of the funnel performed as you moved through the quarter?

The pipeline remains strong. The pipeline typically does not fluctuate much during the quarter. However, we still see ample opportunities, primarily with customers we've already engaged, whether they are large or small. Given the current environment, it is substantially more challenging to reach numerous small businesses. Conversely, we maintain a considerable amount of runway at our top 10 customers, all of whom present significant opportunities for increased ACV as we continue to maintain our strong performance for them.

Understood. I've heard from some other vendors who reported that incumbency has been a critical factor in securing deals this quarter. How do you view the current environment for both capturing new customers and pursuing additional opportunities within your existing customer base?

Incumbency proves advantageous, especially in large organizations where we are well positioned for success. However, if you sell a product where there is only one choice, incumbency may become a limitation. There are myriad ways that organizations can utilize what we offer, and we are finding that our strategic relationships have markedly advanced over the past four to five months. I have been asked if I worry about the potential to outgrow our largest existing clients, but the answer is a resounding no; our opportunities still have a vast upside. We have never been a company that endorses excessive enterprise licenses without consideration. Our intrinsic belief is that there is real potential for growth as we continue to deliver value, enhancing our collaboration.

To provide additional context, approximately two-thirds to 75% of our annual bookings historically stem from existing clients. While incumbency has played a crucial role in driving Pega's growth over time, it is imperative to maintain a balanced view. We must adequately cover our incumbent clients; Pega continues to benefit from successfully penetrating these valuable relationships. However, we have also achieved significant growth in new logos in the first half of the year. While incumbency serves as a boon during economic pressures, our potential to deepen relationships with existing clients while also acquiring noteworthy new accounts remains strong.

We'll take our next question from Mohit Gogia with Barclays. Please go ahead.

First and foremost, congratulations on the solid quarter despite the pandemic. My first question is for Alan. I wanted to delve deeper into the federal vertical; you indicated it was your fastest-growing vertical last year, and several interesting developments have occurred in the first half. Could you elaborate on the successes and the competitive landscape? What correlations exist with the increased penetration into other verticals?

To clarify, our presence in the federal sector was relatively limited five years ago, but it's now been a tremendous growth area for us, and it continues to improve. This goes beyond our recently announced partnership with the IRS, where competition may be intense. We are also collaborating with various government departments, ranging from defense to the U.S. Marshals, aiming to drive efficiency. This trend is apparent not only in the U.S. federal sector but also in nations like Australia and countries in the U.K. Thus, we are pinpointing this as a key vertical for resource allocation to support future development.

Thank you. My follow-up question is for Ken. You indicated that despite the pandemic, a 21% increase in ACV is impressive, especially when several competitors have felt the strain from COVID-19. You also mentioned the opportunity to accelerate ACV growth moving forward. Could you explain the factors driving this, especially considering that two-thirds of ACV growth originates from new bookings with existing clients? Furthermore, how do expansion rates appear to be trending?

Certainly. A close examination of our net retention rate allows us to reverse engineer the 21% ACV growth; our net retention rate falls between 113% and 116%. If we take the 113%-116% net retention rate of existing clients and consider how we haven't even penetrated 10% to 20% of what we could sell to them, we realize there is ample opportunity to generate further ACV growth. Additionally, the federal vertical offers significant potential; they are undergoing digital transformation and striving for cloud use, making them an appealing target for us. This is just one example. We believe there's an abundance of opportunity spread across multiple sectors and client relationships. The ability to leverage digital transformation initiatives enhances our prospects for growth.

We'll take our next question from Yun Kim with Rosenblatt. Please go ahead.

Pega Cloud had an impressive quarter with a sequential ACB business surge; I want to further explore the trends you are witnessing in that specific business line. Are customers making larger commitments? How do deal volumes compare between new and existing customers for the Pega Cloud segment?

Ken can certainly provide you with some statistical insights, but from an overall perspective, we're seeing business flow across all segments. This growth is not solely due to large deals; it targets the existing customer base, which is more balanced.

One specific metric to note is that the average deal size for Pega Cloud and client cloud has remained comparable across the first half of the fiscal year. This data points to a balanced focus on both onboarding new clients and growing existing accounts as well.

Given the prominence of the digital transformation trend, can you share any updates regarding your traction with large global system integrators, recognizing that they have also embraced digital transformation initiatives?

Yes. We are indeed engaging with them, and these relationships have been solidified as we've brought on new leadership to strengthen our partnership strategy. Recently, we appointed a new Head of Pega Ecosystem, a very experienced woman who excels at building connections with major players. Furthermore, Haydon Stafford, our new go-to-market lead, has a strong background in collaboration with Salesforce and Microsoft Dynamics CRM, allowing us ample leverage in our partnerships moving forward.

Excellent! Looking at your transition model, Pega Cloud has accelerated, but are there margins affected, at least in the near term? Moreover, how should we consider margin benefits from total revenue, especially as the numbers grow?

As Pega Cloud accelerates, there are naturally associated variable costs. However, this increased activity results in better operating leverage, granting us a substantial operating margin as Pega Cloud escalates further. Regarding your latter question, bear in mind that during cloud transitions, we ignore perpetual revenue upfront at the outset. Typically, upon completing a transition, we can see significant improvements in margin profiles. By the conclusion of this transition in 2022, you will observe progressive improvements in operating margin each year, particularly as the effects of the cloud transition begin to dissipate.

We'll take our final question from Mark Schappel with Benchmark. Please go ahead.

Well done this quarter. I want to touch upon the new messaging solution and the RPA X-ray Vision capability you mentioned in your prepared remarks. Can you elaborate on the specifics of those products and how they stand in comparison to other solutions available in the marketplace?

I didn’t catch the first part; my line is a bit unclear. What was the first product you were referring to?

You spoke about your new messaging solution and the X-ray Vision application, and I wanted to get more details on each.

Understood! We selectively acquired a company last year that brought incredibly sophisticated messaging technology, which complements our existing offerings. This reflects our commitment to integrating diverse communication technologies with our process automation technologies, creating a cohesive solution for clients. The X-ray Vision capability enhances our robotic process automation by making them less prone to failure and allowing them to self-correct if backend systems change. It offers a level of durability and resilience that sets our offerings apart in the market.

Thank you. This concludes today's conference. We appreciate your participation, and you may now disconnect.