Pegasystems Inc Q2 FY2021 Earnings Call

Good day, everyone, and welcome to the Pegasystems Second Quarter 2021 Earnings Results Call. Today's call is being recorded. At this time, I would like to turn the conference over to Ken Stillwell, Chief Operations Officer and CFO. Please go ahead.

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q2 2021 Earnings Call. Before we begin, I'd 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 expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, 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 of the 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 2021 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 2021 earnings and in the Company's filings with the Securities and Exchange Commission, including its Annual Report on form 10-K for the year ended December 31, 2020 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 these 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, and thank you to our shareholders. I'm pleased with our results for the first half of the year, and they reflect the strong demand for our digital transformation technology and our continued progress towards a recurring revenue model. Our total ACV, which we consider to be the best indicator of our performance, increased by 22% year-over-year as our backlog continued to grow as well. I'm excited that we're seeing really strong cloud adoption, led by Pega Cloud which is the majority of our new business, complemented by great success in client cloud. Now as parts of the world begin to emerge from the acute conditions of the pandemic, digital transformation remains at the forefront of our clients' priorities. It's more apparent than ever that there's no straight line back to a pre-pandemic environment, and clients, I think, are understanding the need for agility and that it's more important than ever if they're going to thrive in an increasingly unpredictable world. We're also benefiting from a renewed interest in workflow, a category we helped pioneer and it is being heavily discussed in the market. However, we believe that our low-code platform and our outcome-centric approach to workflow truly differentiates us and uniquely positions us to help our clients solve their business complexity while maximizing flexibility and delivering excellent value now and in the future. Our strategy is to continue to focus our efforts on building solutions and an ecosystem directed in improving efficiency, usability, accessibility and time to value. When we last spoke, we were days within the PegaWorld Inspire User Conference and saw several significant announcements. We launched the next major release of Pega Infinity that includes enhanced low-code intelligent automation and AI capabilities. This newest version empowers business users to deliver differentiated user experiences with powerful development capabilities that deliver digital transformation at scale for even the largest and most sophisticated global enterprises. Using a center-out approach, the latest enhancements help improve back-end process efficiencies, streamline front-end customer service processes and enable real one-to-one customer engagement to drive meaningful and lasting transformation. Employees can work smarter to drive impactful outcomes, while end customers can enjoy faster, easier and more personalized experiences that truly help our customers deliver satisfaction and loyalty. We also launched our new streamlined Pega partners program, designed to help clients rapidly accelerate their digital transformation initiatives by more easily identifying the partner that best fits their needs through new distinctions. In addition to the implementation role our partners have historically applied, the program makes it easier for them to engage with us in joint solution development, co-sell and even on incentives for referring clients. This is the second year we held PegaWorld Inspire virtually, and we're able to incorporate a lot of learning and innovation to make this year's event even more engaging. I hope many of you were able to join live or can still watch the replays. After more than a year of essentially all global events becoming virtual, we had some concerns about digital event burnout. But we had a great response with more than 18,000 attendees from almost 800 unique client organizations. Additionally, since the live event, we've seen more than 16,000 replay views, significantly broadening the impact and effect of the content. As successful as our last two virtual PegaWorld events have been, we are looking forward to being back in person in Las Vegas in 2022 and hope you'll be able to join us. Now in terms of new business and some of the client work we've been doing. In Q2, we continued to see a good mix of business globally within our key verticals and across all three major solution areas while making some inroads in some emerging spaces. We continue to see both net new business and expansion of business within existing clients, indicative of the continued opportunity to extend our footprint within our installed base. I love winning business, but I'm still most excited by seeing the great results we've been able to help our clients achieve, many of whom did share their stories at PegaWorld in May, like top 10 global bank HSBC is following a highly successful deployment of Pega Marketing and real-time decisioning in Australia by using Pega across the entirety of its retail banking and wealth management customer base. They are maximizing reuse and deploying to a number of markets across multiple sales and service channels. And this results in significant improvements in customer and colleague experience as well as revenue uplift. Blue Shield of California is lowering cost per customer while growing in the highly competitive California market. They are improving customer service to deliver personalization with every engagement, creating an integrated service model that thrills both customers and staff. Fortune 500 insurer Unum has successfully implemented Pega natural language processing to support one of its largest contact centers, providing business users better insight into the types of requests being made by customers. And UPC Switzerland, the country's largest cable operator and part of the Liberty Global Group, is responding to the challenge of massive changes in the telecoms industry. Pega is helping UPC with a radical digital transformation to create seamless customer experience across channels while keeping costs down and productivity up. You can hear more about these successes directly from our clients by watching PegaWorld Inspire replays on our website. Just click on the Events tab on the home page, and I think you'll find it really worthwhile. Now from an operational perspective, we continue to hire strategically, attracting talent from peers and competitors while we invest in retaining and developing our own high-caliber team. Around the world, I continue to be impressed with the tenacity, commitment and passion our team has shown to get us through these new challenges and to show new things to our clients. We're just starting to support travel and allowing people back into offices as, of course, local conditions and regulations allow, while prioritizing the health and safety of our staff, clients and partners. Now look, we all know the pandemic has had a profound effect on how we work. Some of it is very challenging. But it's also stressed our limits in positive ways. And we found innovative new approaches in working together with our clients to become an even tighter and more connected organization. Many of these changes will persist and continue bringing positive change going forward, and we're seeing with many organizations around the world that we've collectively learned that we can be much more flexible than we thought possible. And this creates new opportunities from everything from recruiting to retaining the best people, to being able to engage differently with our clients. You may have seen that our headquarters building in Cambridge was recently sold, and we are ending our lease there. Rather than simply find another similar space in Cambridge, we took this opportunity to rethink what our workforce would look like in the future based on employee surveys and discussions with peers. As a result, we're leasing a smaller headquarters in Cambridge that will include a state-of-the-art client briefing center and also a second space west of the city in Waltham, which we're building out now and will be custom designed to support our future workforce. We also have beautiful offices in Sale of New Hampshire north of the city. We think, for example, this approach will give current and future staff more options for where to work and support the flexible work environments that we see employees seeking. We believe our office should be a magnet, not a mandate, and that this approach will benefit our recruitment and retention efforts. So in summary, I think we're executing well on our strategy, and this is reflected in our results for the first half of 2021. We're making terrific progress on our transition to the recurring revenue model. Our clients are leveraging our software to address both immediate and short-term challenges as well as preparing and building for long-term opportunities. I think we're making the right strategic investments to take advantage of the heightened focus on digital transformation, and we have our unique outcome-driven workflow that will enable this to be possible, all while we are collectively working to judiciously manage margins. And we continue to see significant opportunities among both our existing and new clients. To provide more color on the financial results, let me now turn this over to our COO and CFO, Ken Stillwell. Ken?

Thanks, Alan. For those of you who are interested, I'm excited to say this is my 20th earnings call as Pega's CFO. The economy certainly looks like it's recovering, and we continue to execute well on our cloud transition. Now during this transition, there are two key metrics that I've mentioned, that are how we measure our business success. The first key metric is the growth in annual contract value, we call ACV. ACV growth represents the annual contract value of recurring arrangements between Pega and its clients. I'm really excited to see Q2 finished with ACV growth of 22% year-over-year, inclusive of a 3% to 4% tailwind from FX. Total ACV reached $899 million, an increase of $161 million from the same period one year ago. The biggest contributor to our ACV growth was Pega Cloud. Pega Cloud ACV grew by an impressive 46% to $307 million. Client Cloud ACV grew by 12% year-over-year, reaching $592 million. The second metric to measure our business success during the cloud transition is growth in remaining performance obligation or backlog. Total backlog at the end of the second quarter crossed the $1 billion mark to $1.03 billion, an increase of 26% from a year ago. The growth in current backlog, which is backlog of the one year or less, was also strong, increasing 23% to $567 million over the same period, powered by current Pega Cloud backlog growth of 47%. With these ACV and backlog metrics in mind, Q2 was a solid quarter, and it was sequentially much better than Q1. As I explained last quarter, our cloud transition includes three major phases. Pega is currently in the second phase of the cloud transition. I call this the revenue growth transition. In the first few years of the cloud transition, the revenue growth rate declined as new client commitments transition from perpetual license agreements to subscription arrangements. Most of these new arrangements are subscription bookings and go into backlog for recognition as revenue in future periods. For example, in the first half of 2018 and '19, Pega's total revenue growth rate declined year-over-year. However, once a company passes the midpoint of the cloud transition, revenue growth starts to accelerate again and can exceed the ACV growth rate, which is what Pega experienced in the first half of 2021. Total revenue in the first half grew by 30% year-over-year, reaching $639 million. This is the fastest total revenue growth that Pega's business has experienced in over a decade when comparing first half revenue of the current year to first half revenue of a prior year. However, it's important to point out that total revenue in the first half of 2020 included the impact of the pandemic, a slightly lower renewal period and the revenue trough of being in the middle of the cloud transition. Subscription revenue for the first half of the year was $511 million, a 37% increase from the same period one year ago. Subscription revenue, which includes Pega Cloud and maintenance, now contributes about 80% of total revenue from just over 50% when we started the cloud transition in late 2017. You'll notice that we disclosed in our 10-Q that in the second quarter of 2021, we had a large existing client that renewed an existing multiyear contract also expanded their use of Pega software and extended the term of the agreement earlier in the year than we had anticipated. The accounting for this deal under 606 led to over $30 million of reported revenue in Q2, which would have otherwise been anticipated in future periods. That deal was the biggest single variant to our expected revenue results for the quarter and the first half. A core element of our go-to-market strategy is to increase sales coverage for our large target accounts, win new deals and cross-sell and up-sell into those client bases. Our first half results are just one more proof point that our strategy is working. Some of our clients are doubling or tripling down on their Pega investments because they need a low-code platform to help them advance digital transformation initiatives and improve workflows. As a result, we plan to continue to invest in technology, leadership and additional sales capacity as we win more than our fair share of the $65 billion-plus market opportunity for digital transformation. Our non-GAAP earnings for the first half of the year was $42 million or $0.49 per share. This improvement resulted from a combination of solid revenue growth and improved expense management, however, was impacted by the large term deal in Q2. I want to reiterate that ACV and backlog are the two most important growth metrics for the business. Pega Cloud is our Software-as-a-Service offering. For these customers, we manage the cloud infrastructure on behalf of our clients. Client cloud revenue includes revenue from maintenance and term license contracts. The client manages these deployments on the infrastructure of their choice. The final phase, the cloud transition, is the cash flow transition. We expect our cash flow will normalize in the coming years and has already improved in the past year. We believe it will be important to balance growth and profitability over the long term. We think of the Rule of 40 metric, the combination of ACV growth and free cash flow margin, to calibrate the trade-off between profitability and growth. We continue to expect that as we complete the cloud transition in 2023, we will make increasing progress toward that goal. In conclusion, this was certainly a solid quarter on all fronts.

First, we'll go to Chris Merwin from Goldman Sachs. Your line is open.

This is Kevin on for Chris. I had a question on the partner channel. Given you've had several changes in the way that you collaborate with your partners, are you seeing any early signs of improvement in engagement? Thanks.

Yes, this is Alan. I think the engagement is visibly more intense. And we've added to that team to be able to work more closely with partners. And I'll tell you that the level of partner engagement on both actual deals and prospective opportunities are both visibly up. So I'm feeling good about the effort we're putting in our partners. And obviously, we need to continue to cultivate and develop that. But we're hearing from them a lot of enthusiasm about Pega, which is great.

Great. And then maybe one more for me. It's great to see ACV growth accelerate. Curious about kind of the CRM side of the business, how has deal activity been in that segment? What types of use cases are you seeing with your customers?

Well, for example, one of that big expansions that we talked about I think is very squarely in what people would consider to be a set of CRM and broad CRM use cases. I think CRM, of course, means different things to different people, but the significant majority of our software is used and why is that possibly impacting customers while trying to save the place the customer our client money. And those are just going to continue, and we see a lot of interest and a lot of hunger for continuing to improve customer engagement.

And next, we'll go to Jack Andrews from Needham. Your line is open.

I want to ask, Alan, you mentioned renewed interest in workflow in your prepared remarks. I was curious if you could drill into what specific types of use cases are you seeing customer interest in on that front?

I think it varies somewhat by industry. In healthcare, discussions often center on enhancing care management and population health to improve lives while reducing costs, which is ideal. In financial services, where we have a strong presence, many workflows focus on eliminating what was once considered the middle office and substituting it with high levels of automation. This allows for a seamless transition from various channels to execution, whether through a Pega front end or other integrations. I've never been particularly fond of the term workflow, although it has gained popularity recently, and while we're quite proficient at it, I prefer the term work do. The goal isn't to simply flow the work around; it's about actual execution. That is our true strength, and I believe we are far ahead of many competitors in this area. I'm pleased to see the term gaining prominence as it highlights our unique advantages.

Appreciate that. And just as a follow-up question, could you update us in terms of your hiring plans for the year? And any metrics in terms of just productivity and things like that? And how we should expect the balance of hiring to unfold throughout the year?

I will now hand it over to Ken for the numbers. I just want to mention that the hiring done in a given year is really aimed at enhancing productivity for the following years. So, as we move into the second half of the year, any actions we take won't be recognized in terms of productivity until we progress into next year, due to the nature of onboarding and related processes. Ken, could you provide your insights on how you anticipate those staff numbers will appear?

Yes, definitely. So Jack, we were aiming for around a 20% increase in our selling capacity. My target for the year is close to that figure. However, we've experienced slightly slower growth in the first half of the year. The growth hasn't been consistent. It’s possible that we may fall short of that growth rate by the end of the year due to the competitive market conditions. We also approached hiring more cautiously in the first quarter because COVID was still an issue. That said, the economy is performing well, and our clients are very active. As Alan mentioned, the hires we make this year, even those in this quarter, will begin to affect next year positively. Essentially, we need to maintain a solid growth rate, so you can expect that our final figure will likely be somewhat below 20% for the year.

And next, we'll go to Mark Murphy from JPMorgan. Your line is open.

Yes, thank you very much. I'm interested in whether you have any metrics you could provide that might help us just understand your scale of adoption in the low-code market? For instance, just how many Pega users or how many seats do you think you have that would say that they are sitting in developers that kind of sit on the business side rather than on the IT side? And just what does that mix look like for you in terms of seats on the IT side versus the business side?

We've been working over the past 24 to 36 months to make our technology more accessible to businesses through our Pega Express methodology. If you visit our website, you can view short videos and customer testimonials that showcase our efforts. Our software is designed for business accessibility, avoiding basic solutions that might compete with spreadsheets. The recent release of version 8.6, announced at PegaWorld and now shipping, shows our commitment. We have numerous clients in the low-code factory space enabling their business users to build apps while fostering collaboration between business and IT, aiming to reuse resources while ensuring security and reliability. Reflecting on some of the low-code trends reminds me of past tools like Lotus Notes that had limited longevity. I’m excited about empowering business developers, which I consider a more appropriate term than citizen developers, to engage in meaningful app development for their organizations. These projects can start small but evolve significantly, with a couple of Fortune 50 clients having empowered developers who created over 500 applications, utilized by tens of thousands of staff, all coming from non-traditional IT backgrounds.

Thank you for that, Alan. I would like to follow up on the customer engagement segment regarding the question from Chris Merwin’s team. Could you elaborate on where you observed the strongest growth factors in Q2? Was it more in customer service and support, sales automation, or perhaps in the cross-sell and next best action areas? I'm trying to understand what aspects are being prioritized as the economy begins to reopen and gain momentum.

A lot of next best action, coupled with service and end time fulfillment. There's a lot of people who've seen the bailing wire in their internal operations and know that they need to really make this better, trying to make things more efficient. And that is primarily something that has to do with customers but is about an efficiency play and about an end-to-end automation play inside those organizations. So I'd put it very much more in the sort of fulfillment and deepening client relationships. I think a lot of organizations have realized that the way they're going to get through sales is, in many cases, going to be by deepening existing relationships as opposed to necessarily going out after a whole source of new companies. And we're being used heavily in those types of environments.

Okay, understood. I have a final quick question for Ken. You mentioned the significant deal that concluded in Q2, which helps clarify the volatility in the term license line. It seemed like there might have been a bit more to it. Can you explain when we examine the potential in that term license line, how many unique deals are contributing to the overall increase?

I’ll address your question more directly. I believe that some perspectives on our Q2 revenue were likely a bit conservative regarding the term line. To begin with, we typically don't provide guidance, but we certainly recognized an opportunity to perform well in that area. That’s one observation I want to share. Additionally, aside from the $30-plus million deal, in a typical quarter, there are about 50 deals that contribute to revenue, but only a very small fraction of those typically exceed $1 million. Therefore, we shouldn't view Q2 simply as the big deal plus two others. There were likely lower expectations for the term line than we had anticipated based on the sell-side targets.

And next, we'll go to Rishi Jaluria from RBC. Your line is open.

Hey, guys. Thanks for taking my question and then nice to see continued solid execution. I wanted to start off by maybe drilling a little bit more into the ACV and cloud numbers because we did see a bit of a drop-off in Pega Cloud ACV growth rates. And look, I understand the story about Cloud Choice. But maybe you could help us understand that as well as the slight decel that we saw on the cloud revenue side. Were there any factors that you'd call out in the quarter? And should we expect that line to maybe reacquire over the coming year? And then I've got a follow-up.

Yes, let me address that. I understand we just released earnings very recently, so you’ll need some time to absorb all the information. However, I want to emphasize that the sequential growth in Pega Cloud ACV in Q2 was significant, likely our strongest quarter for Pega Cloud, excluding Q4. It was a solid quarter for sequential growth in Pega Cloud ACV. Currently, we're dealing with a larger denominator when calculating these growth figures. Therefore, maintaining a 50% growth rate indefinitely as we achieve higher Pega Cloud ACV numbers—like $300 million, $400 million, $500 million, and $600 million—may not be realistic. It's important to note that this figure is based on a 12-month timeline and is influenced by previously reported quarters. What I can say is to focus on the sequential ACV growth from Q1 to Q2. If my calculations are correct, we increased Pega Cloud ACV by approximately $25 million and grew Client Cloud by about $21 million. Those growth figures are impressive. I don’t believe there is any weakness in Pega Cloud or in our cloud revenue in general. Sometimes, the math can seem confusing depending on the quarter we’re looking at, especially with a larger base number involved.

Okay. Great. No, that makes sense. I totally understand. And then following up just on the ACV line, it's nice to see ACV growth tick up a point or two on a constant currency basis from last quarter. I imagine you still have ambitions to not see it get back up to that 20% mark that it had been pretty consistently above but accelerate further from there. Can you maybe talk about what kind of the roadmap to drive that reacceleration looks like? And what sort of progress you're seeing on some of those initiatives, including the improvement in sales motion and better leveraging the partner ecosystem?

I want to address one aspect of this, and Alan, please feel free to add your thoughts. When comparing 2021 to 2022, 2023, and 2024, we are definitely expecting our ACV growth in constant currency to remain around 20%, and ideally even exceed that figure. That's our goal and hope for the year. However, I don't anticipate significant opportunities to accelerate ACV in 2021. We have a new sales leader and a new go-to-market strategy that was implemented last year, along with some changes and a new partner approach. Given these factors, it seems unrealistic to expect a major impact in 2021. I could be mistaken and would be pleased if I was, but I want to set realistic expectations. The years 2022 and 2023 are when we should start seeing the benefits of the strong work that Herde and his team are doing to enhance partnerships and operational effectiveness. We're optimistic about improvements in 2022 and beyond, but for 2021, I definitely expect ACV to improve from its current state. However, expecting a significant acceleration may be overly ambitious, considering our current growth stage.

Got it. Okay.

Just to provide some insights into the future, I believe Ken's perspective on 2021 reflects our current position and the recent changes we've implemented. If you look at LinkedIn, you can see the senior talent we've recruited from several outstanding organizations. We have significantly expanded our senior leadership in Europe, and we are also making additions in the APAC region and the Americas. We are bringing in these individuals because we believe the market has the potential for quicker growth than in the past. Our views on what we are observing remain unchanged. Our clear objective for 2022 and 2023 is to gain a return on the talent we've brought in. We'll see how we perform this year. Since it takes time to onboard new hires and get everybody acclimated, there is a bit of grace period for them, but I am very enthusiastic about the exceptional talent we have been able to attract. So, we are excited.

Yes, I understand. That’s helpful. For my last question, I'd like to revisit the topic of hiring. Many companies in the software industry are mentioning challenges related to labor shortages and finding the right talent. Can you share what your perspective is on this? If I remember correctly, during the height of the pandemic in April and May, you made a conscious choice to continue hiring rather than implement a hiring freeze to take advantage of the situation. Could you discuss how those hires have turned out? Additionally, what position would you be in if you had to enforce a hiring freeze like many software companies did?

I believe that the hiring impacts us in various areas and in multiple ways. As we discussed regarding our go-to-market strategy, we've assembled a team that presents exciting opportunities for the next four years. From a product perspective, at PegaWorld, we continued to build on what we announced 2.5 years ago with Project Phoenix, which focuses on advancing our products to be cutting-edge and presented in more innovative ways. I was impressed with what we showcased at PegaWorld. The concept of a process fabric that can integrate processes across different systems, including those outside of Pega, is right on track. We are working on a highly advanced Pega user interface and a digital experience API that can function in various environments. I am enthusiastic about our progress, and we have dedicated time to enhancing our website. You can expect to hear some outstanding case studies that illustrate how our ability to bring in the right talent and develop our product and culture is strengthening our go-to-market approach. Overall, I feel optimistic about our situation.

And next, we'll go to Steve Koenig from SMBC Nikko. Your line is open.

Hi, gentlemen. Thank you. I've got one for Ken and then one for Alan, a multipart question. So Ken, you talked a little bit about what the quarter looked like taking out the big term renewal. So we heard about it wasn't a quarter driven by other. Cloud was strong sequentially, ex that term renewal, any color you can give us on duration, cloud mix in your business and any conversions to cloud? I think you have some big ones in the year ago quarter. And then I got one for Alan.

Yes, we're quite pleased with our federal business. I was just in conversation with the CEO of Services Australia, which represents the Australian federal business. We've experienced significant success not just in the U.S., but they've actually published an article about their growing collaboration with Pega in Australia. Additionally, Germany has been fantastic for us, as has the U.K. government. It goes beyond just our achievements with FedRAMP. Some of you may be aware that we won the census a few years back in a highly competitive environment, and I'm thrilled to report that it's now considered a success. We've received feedback indicating that they're very satisfied with how everything unfolded using our software. We have numerous agencies we're collaborating with, some of which hold significant potential, such as the IRS, although we typically don't announce these too far in advance of their rollout. However, you can find information about it on some federal websites. Timing can be difficult to predict, especially in government, which can be more complicated than in other sectors. Overall, I believe our government segment will continue to remain very strong as governments recognize the need for modernization, and there is substantial demand. We are genuinely excited about this business.

And we have no further questions at this time.

Well, that's great because we were going to have to wrap up. I don't want to take away from Ken's moment, but I want to congratulate him on his 20th earnings announcement. It's been a privilege to go on this journey with you as we transition from a very different company in the markets to one that I’m extremely excited about as we enter the final phases of the cloud transition. It's incredible to acknowledge that this is my 100th earnings call, and I'm very grateful to the investors who have been part of this journey. I want you all to know that we have a fantastic team working hard to meet your expectations, and we are very excited about the potential ahead. So, thank you for the 100 calls, and we're looking forward to getting back to work for you. Talk to you all soon.

And that does conclude our call for today. Thank you for your participation. You may now disconnect.