Pegasystems Inc Q3 FY2021 Earnings Call

Good day, and welcome to the Pegasystems Third Quarter 2021 Earnings Results Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Pegasystems COO and CFO, Mr. Ken Stillwell. Please go ahead, sir.

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q3 2021 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 expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, projects, forecast, guidance, likely and usually or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date 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 Q3 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.

Thanks, Ken. And I'd like to say that I'm really pleased with our results year-to-date, and we continue to see strong adoption of our low-code digital transformation technology. Through Q3, our total annual contract value, or ACV, which we think is the best indicator of our performance, increased by 22% year-over-year and our subscription revenue grew 32% year-over-year. The benefits of our recurring revenue model are increasingly visible, and we're happy with our progress. Now to provide an update on the pandemic and some industry trends. Though the status of the pandemic still varies region to region, we are seeing the global economy recovering. There are positive signs that the worst is behind us. The demand for digital transformation solutions continues to be strong and is expected to be one of the fastest-growing enterprise software markets in the coming years. The IDC reports that the market for digital transformation software is growing globally at about 19% CAGR and is expected to reach $619 billion by 2024. We believe we're in a great position to benefit from the growth in this market, driven in large part by the challenges in the last 18 plus months. Organizations know they must adapt to today's needs while preparing for inevitable additional changes that will come tomorrow, and that's where Pega comes in. In an unpredictable world, we help our clients crush business complexity, so they can work smarter, simpler, and faster. Our tagline, Build for Change, is as relevant as ever, given the imperative that organizations establish a technology and a business architecture that empowers them to adapt and thrive in constantly changing markets. The Customer Decision Hub, our real-time decisioning engine, helps customers predict their customers' needs, personalize interactions, and deliver across channels to deepen relationships and maximize value. Our customer service solutions leverage automation and AI, so representatives can handle any engagement quickly and effectively, ensuring customers get what they need. Our intelligent automation solutions boost efficiency by streamlining any process, often the most business-critical sophisticated workflows that require a high degree of intelligence and automation. We continue to benefit from offering our customers Cloud Choice, which we pioneered in 2017. Offering cloud alternatives plays perfectly to where we see the future going. Historically, organizations have thought of and implemented cloud as a collection of islands, and that's fine for many types of cloud usage. However, Pega is often used as a strategic backbone for an organization. And in those cases, clients often want to weave Pega into and across their existing cloud infrastructure. And that's what Cloud Choice does. It lets Pega become part of their fabric, part of a client's strategic future, improving their effectiveness and fostering a longer-term commitment to Pega. CIOs are aggressively scaling up cloud capabilities. This makes our cloud solutions more effective, whether we're operating them or the client is. Regardless of how our clients deploy, the software is the same, so they benefit from the same industry-leading software and all that comes with it. A center-out approach that puts the outcomes they are achieving at the center of their solution, design thinking that brings people and technology together to design and deploy innovative solutions in weeks or even days, and the industry's only low-code platform built with a prescriptive approach to business and IT collaboration. We're proud of how central our software is to the strategic operations of our clients, many of the most recognized and successful brands on the planet. We are most successful when we engage with senior leaders in these large enterprises where the focus is on strategic big-bet initiatives that are crucial to their success. This means the commitment on both sides can be very significant. And once clients experience the value we bring, we have a tremendous opportunity to deepen and expand those relationships. For example, on the commercial side of our business, in this last quarter, we expanded our footprint with three of the world's largest telecommunications companies, three of the world's largest financial services companies, and three of the world's largest healthcare companies. Just this past week, our client, Lloyds Banking Group, won a Digital Transformation of the Year Award for the work they are doing with Pega, which really gives their employees and customers the best experience at key moments of truth. I'm very proud of the work that we're doing together. Additionally, the government sector continues to drive significant business, and we increased our presence in government clients in every region around the world. Government leaders know that the next few years are going to be challenging, and that the flood of service and program needs we have experienced over the past year and a half will continue. They know they have to deliver a wide portfolio of critical services, and yet outdated systems, inefficient processes, and disconnected channels can slow down that service and make it hard to keep pace with needs and changes. We help government clients go live quickly and drive amazing outcomes, whether it's starting with one small critical application like we rolled out for the State of Bavaria, which, by the way, has led to new opportunities across EMEA, or at massive scale like at the US Census. We've been wildly successful with our government clients over recent years, finding the platform is built for change, sophistication, and scale. Our outstanding work for the Census is documented in a recent video available on pega.com, highlighting success. As Michael Thieme, the Census Assistant Director to the Decennial program said, everything worked as it was supposed to. It was smooth. I would almost call it historically smooth. In Australia, our software is being used by the Department of Home Affairs to develop their Permissions Capability Platform as part of an overhaul of their Visa processing system. They want an integrated enterprise-scale workflow system capable of being used across the government. They expect to roll out new digital incoming passenger cards, which will include vaccination status to airports around the country by the end of the year, paving the way for border reopening. In the UK, our software is being used by the Royal Navy and Royal Air Force to develop new end-to-end recruiting platforms. The goal is to provide a better digital experience for the 180,000 annual potential candidates and help reduce recruitment cycles. Now as we emerge from the pandemic, we are gauging our clients and partners' comfort level in meeting in person, and we're gradually bringing back in-person events and getting our selling teams back on the road where we can. We continue to raise our visibility among our key clients and prospects with targeted selling and marketing approaches. For example, you may have seen that we sponsored the Ryder Cup this year, a new initiative for us to increase our visibility, which provided an excellent opportunity to connect with many of our more senior and strategic clients and partners. We just held our inaugural Executive Partner Advisory Council meeting with senior contexts from some of our most strategic partner organizations who have broad and deep established relationships with many of our clients. We're excited to hold this meeting in person. Our new streamlined partner program that was rolled out this summer is being well received, and we will continue to focus on deepening these relationships to make it easier for partners to engage with us in joint solution development, co-selling, and client referrals. As a result, we're seeing increases in partner engagement and partner-sourced business, and we believe we have plenty of opportunities to fully leverage a strong and growing partner network, and we feel very positive about the overall direction and momentum. In summary, I'm pleased with how we're executing on our strategy and how it's reflected in our results in Q3. We continue to make excellent progress toward a recurring revenue model. Our clients recognize the need for digital transformation solutions that can solve both their short-term challenges and long-term strategic needs. We feel we are uniquely positioned to help them and will continue to focus on strategic investments to leverage this great opportunity while thoughtfully managing margins. To provide more color on these results, I'll now turn it over to our COO and CFO, Ken Stillwell. Take it away, Ken.

Thanks, Alan. Q3 was another strong quarter following on the heels of what was a very strong Q2. When it comes to our most important metric that we measure as our business success, ACV continues to be the most important metric, and that's the growth in our annual contract value. In fact, if you look at the combined Q2 and Q3 of 2021, we added an impressive net new ACV gain of $95 million, an increase of 45% year-over-year. It's really nice to see such strong momentum through what is traditionally a slower ACV growth period for Pega, which is the middle of the year, the Q2 and Q3 time period. As you know, in late 2017, we started a multi-year cloud transition, moving from a company that primarily sold perpetual licenses to a company whose go-to-market motion is focused on selling subscriptions. Today, almost all of our new client commitments are Cloud Choice. These clients are either subscribing to Pega Cloud, a cloud deployment that Pega manages, or Client Cloud, a cloud deployment that our clients manage on the cloud of their choice. As a result, our total software revenue mix has shifted to subscription. In fact, through the first nine months of 2021, more than 97% of our software revenue is, in fact, subscription. Pega has remade itself as a subscription software company over the last few years, a significant achievement that we're very proud of at Pega. During our transition to the subscription model, there are two metrics that properly measure our success. The first and most important metric is growth in ACV, as I mentioned earlier, representing the annualized value of our active client contracts as of the measurement date. In Q3, ACV grew 22% as reported and 21% in constant currency from a year ago. Since ACV growth had dipped below 20% constant currency earlier in 2021, I'm really excited to see total constant currency ACV growth accelerate back above 20% in Q3. One thing to clarify with our ACV growth is that it came about a little differently this quarter with a higher client cloud mix than in recent quarters. We're not entirely surprised by this mix as we've seen our clients become increasingly sophisticated in adopting and managing their own cloud environments for their most mission-critical tightly integrated applications. We believe increasing adoption of Client Cloud reflects this dynamic. Going forward, we continue to believe that Pega Cloud will be the faster-growing component of ACV, but it is encouraging to see our clients truly embracing Cloud Choice. An interesting note is that almost half of our clients who have ACV greater than $1 million per year leverage both Pega Cloud and Client Cloud. We view this as a validation of our Cloud Choice strategy. Total ACV growth is what ultimately matters for our strategy. Let me explain why. First, unlike other enterprise software companies, Pega Cloud and Client Cloud are, in fact, the same underlying technology. The only difference between the two offerings is who manages the solution and where those solutions are managed. Second, we continue to view our strategy as providing customers with Cloud Choice. But remember that the Cloud Choice is the choice to deploy with Pega Cloud or Client Cloud. It is a key differentiator for us. Oftentimes, our clients tell us that Cloud Choice is a key differentiator for us in the enterprise space. These clients have complex needs; therefore, they require flexibility when deciding how and where to manage their enterprise solutions. Another important metric to measure our success during the cloud transition is our growth in remaining performance obligation (RPO), sometimes called backlog. Total backlog represents clients' contractual commitments that are expected to come into revenue in future periods. Total backlog increased by 23% from Q3 2020 to Q3 2021, increasing from $838 million to just over $1 billion. It's tremendous to see total backlog increase by almost $200 million in 12 months. It’s worth mentioning that maintenance backlog growth also accelerated through 2021. When a client cloud deal is booked, a portion of that transaction is recognized as term license subscription, and a portion goes into maintenance backlog to be recognized in future periods. The strong growth in maintenance backlog is a direct result of our strong client cloud bookings during the last 12 months. I've often advised investors not to get too hung up on the accounting of ASC 606, but instead, to think about combining term ACV and maintenance ACV as those together represent client cloud ACV. Turning to revenue, total revenue through the first three quarters of 2021 increased 25% year-over-year. This increase was driven by Pega Cloud revenue growth, which increased 49% over the same period. Subscription revenue jumped by 32%, reaching $708 million through the first three quarters of 2021. Over this period, subscription revenue made up just under 80% of total revenue, up from 75% of total revenue during the same period last year. Our success in closing new and expanded Pega Cloud and Client Cloud deals drives our growth and term license cloud and maintenance revenue, which makes up our subscription revenue sources. Several factors are powering the subscription revenue growth. We've clearly expanded our total addressable market because of the pandemic. Companies are adopting modern software solutions to automate manual business processes across all of our key industries: financial services, insurance, telecommunications, healthcare, manufacturing, and the public sector. We are still in the early innings of digital transformation, which is accelerating across the globe, and Pegasystems is at the center of this opportunity. Our software is clearly becoming more important post-pandemic. Companies are embracing a hybrid workforce, which means more digital engagement between clients and their customers as well as their team members. In conclusion, we delivered a great third quarter, highlighted by solid total ACV growth, and we're looking forward to closing out a record 2021. As always, Q4 is a critically important sales quarter, and we are laser-focused on finishing the year strong and positioning our company to deliver in the future. Operator, please open the line for questions.

We'll take our first question from Steve Koenig with SMBC Nikko.

I'll do one for Alan and one for Ken. Alan, could you give us an update on where you are in terms of the journey you launched with Pega Infinity? I think it was two years ago now—COVID has made my sense of time warped sometimes. Where are you with multi-tenancy, microservices, and IDE, all the interesting stuff you're adding to the platform? And then I've got one follow-up for Ken.

Steve, at the risk of really putting us all in a time warp, it was actually over three years ago that we announced what we call Project FNX, which was a carefully crafted strategy to build additional capabilities into Infinity so customers wouldn't have to wait until everything is done to take advantage of them. What I'll tell you is that with our 8.6 release, which is in our customers' hands now for months, and our 8.5 release, we were actually able to implement very important capabilities. Most recently, the ability to use what we call the DX API, the digital experience API, which is now being used by numerous production customers, giving them a real cross-channel way of having the brains and the process from the Center-out architecture drive their front ends. We have numerous clients using it, and we're now actually able to generate state-of-the-art React-based desktops, which are available to clients on early adopter status in H6 and going to be broadly available in H7. So very substantial functional and compelling improvements. From a microservices point of view, we have very substantially taken the Pegasystem and subdivided it into key microservices and recurring services. Concepts like multi-tenancy are built in a variety of capable ways, and I think we will continue to offer certain clients the ability to run in their own set of tenants. Looking ahead a little more, you'll see us offering software to perhaps new cadres of clients that is the right way to enter certain sectors and segments of the market. I'm very pleased with the progress of Project FNX, and you can see it paying off today and arranging for us to pay off even more in the future.

And then quickly for you, Ken. I think you mentioned that cloud was a really big part of new bookings. I think last quarter, it might have been 60%. It sounds like it was even higher this quarter. Could you give us some color on that? And then just to add to that, any color on how sales productivity is trending after all the hiring you've been doing and how it's been impacted by the go-to-market changes that Pega has made?

Yes, let me clarify one thing. Our overall Cloud Choice is accelerating growth. For the year, Pega Cloud to Client Cloud was still about 50/50 in percentage mix between the two of them, so nothing noticeable there. Client Cloud was stronger in Q3 than Pega Cloud just slightly. Last quarter, they were close; I think Pega Cloud was maybe a little stronger. They've been pretty equivalent. We've seen good balance there. So just to clarify what you'll see in the financials. On sales productivity, what's interesting is because of the significant growth we had in Q2 and Q3, sales productivity for just these quarters has certainly strengthened. Q1 wasn't as strong in overall ACV growth, but Q2 and Q3 have been moving in the right direction.

We'll now take our next question from Jack Andrews with Needham.

I was wondering if you could provide more details just on your partner progress. Is there a way to frame what proportion of your opportunities are now influenced by partners these days?

A significant majority of our opportunities have very meaningful partner engagement. I would say it's north of 80% where a partner is meaningfully engaged. This has been a key part of our strategy, and we're excited about it. There's a lot more opportunity here as we continue to move forward, and we believe our strategy needs to be extremely partner-friendly.

Jack, I'll add one other qualification to what Alan said. Although partners are involved in many of our campaigns, I would still say there is a lot of upside in terms of the deals partners are bringing us. We are still sourcing deals in our traditional fashion, and partners are starting to refer more to us, but we're still in the early stages of that.

As a quick follow-up. Alan, you mentioned that you're most successful when you have senior leadership engagement. I was wondering, has there been a change in either the frequency or intensity of C-level conversations that you're having these days?

I think we've been able to meaningfully increase that. As we've added more senior people who are comfortable dealing at the COO, CXO, even CEO level, those conversations have increased. The pandemic has bizarrely been helpful because you no longer have to struggle as much to get schedules perfectly aligned. People are kind of stuck, so it allows for finding the right windows. I’m continuously involved with clients, and that's also true for senior leaders in Pega who are responsible for products and our client relationships.

We'll hear next from Steve Enders with KeyBanc.

I just wanted to get a better sense. We hear a lot in the news around great remuneration and people worried about potential hiring challenges. When you go back to your customers, is there an increased focus from them around investing in their own automation initiatives given these potential challenges they're seeing within their own employee base?

I think that's a really good question. Over the next several years, we believe that as a code that writes software. Organizations want a lot of control over their destiny and do not just want to dump their systems in the hands of some off-the-shelf solutions. However, they realize how increasingly complex technology is, along with heightened security concerns and the need for agility. Our low-code implementation works strategically well with clients who face multiple complexities—they're really interested. Many are now more open-minded about doing it differently because they understand how hard it is to build and retain a team with such skills. They need new ways of doing it, and I think this will become increasingly important over the next 24 to 36 months.

Then, Ken, maybe just a housekeeping question. Good to see ACV growth come in at 22%. Just wondering what the constant currency growth was there and if there’s any FX impact this quarter?

Constant currency was around 21%. There wasn't as much of a currency tailwind in Q3, as the dollar started to return to where it was towards the end of the year. We had a reasonable acceleration in Q3 for constant currency growth.

We'll hear next from Pinjalim Bora with JPMorgan.

Ken, the mix shift to Client Cloud versus Pega Cloud, is that impacted by more regulatory industries this quarter who want to manage their own infrastructure? Are there any particular use cases that you're seeing that inform the decision between in-house versus using Pega Cloud? On the other side, you mentioned Pega Cloud growth should pick back up; are we suggesting that we are in a trough in the Pega Cloud growth currently?

Let me jump in for a second. It’s really important to understand how we're discussing cloud. Ken mentioned that our focus is on cloud solutions. Whether that cloud is operated by a customer wanting it woven into their full backbone or whether they choose to have us operate on the Pega Cloud, these integrations need to go across industry-standard interfaces. That's an architectural choice that reflects customer thinking about the state because the good news is that customers think of us as integral to their technology architecture. We do not draw a distinction in how we compensate our salespeople; ultimately, it's about ACV. We just want our clients to have what makes sense for them strategically.

Who’s more likely to buy Client Cloud? Use cases do play into it. Larger organizations using Pega centrally inside their tightly integrated mission-critical environments might want to manage that themselves, which would lead them to choose Client Cloud. As I said, don’t think about acceleration or deceleration; Pega Cloud will still be the fastest growing regarding percentage growth, even if we end up with 50% Client Cloud and 50% Pega Cloud.

Can you just discuss the normalization aspect of cash flow as we end this year and next year?

Think about operating cash flow connecting to what we call non-GAAP income. The actual cash balance is impacted by other factors like stock buybacks. Just think about non-GAAP EPS or non-GAAP income as very consistent with operating cash flow. Overall, we are still under the same time frame for normalization. Depending on the structure of the deal and the timing of billings, things can shift between quarters. Q4 and Q1 are typically our stronger billing collection quarters because of the activity in Q4, including renewals.

We'll now take our next question from Phil Rigby with RBC.

So I wanted to ask how has Pega been progressing with the new go-to-market update vision and organizational changes that Hayden laid out at your Analyst Day? Are you pleased with your progress and where that stands, or do you see areas where you think more work could be done?

I'm very impressed by the talent we've found and attracted under Hayden's leadership over the last six to nine months. I don't want to offend anybody regarding the visual timeline, but it's definitely impressive talent with terrific backgrounds from competitors. Many are eager to leverage what’s perceived as a superior technology. I'm excited as we enter January’s sales kickoff; we will be launching the team we've been developing. Just look at the talent assembled and what they bring to the table.

Alan, I just added you on LinkedIn and will start tracking that talent progression.

You should do it. If you go to the company page and look at insights, there's a tab that showcases recent senior hires.

Absolutely, we’ve been tracking that part. Ken, I have to ignore you a bit. Alan, I have another question that might be more in your direction here, kind of architectural. We’ve been hearing about the importance of event-driven architectures for building scalable infrastructure. How do you consider Pega's capabilities to leverage event streaming technologies or event-driven automation in workflows?

I think we're state-of-the-art. As part of Project FNX, we early on made it so our system accommodates events as first-class citizens. We've plugged into Kafka, enabling numerous customers to consume events, applying a combination of real-time decisioning, rules, process AI, and our core workflows. That plays strongly. A lot of what's out there isn’t very good, and I’m proud of what our team has built in this area.

We'll hear next from Mark Schappel with Loop Capital.

Alan, a question for you. Historically, M&A has played a modest role at the company. With the business model transition winding down, do you see M&A playing a larger role?

Well, we keep an open mind. The challenge here is when we go to market; a critical element we tell clients is that we’re not a frankenstack. We do buy things, but we believe they need to be woven into a consolidated architecture. We aren't expecting to be a company that's like many competitors, buying revenue streams. Our customers require a high level of technical integrity. So, while we could become more amenable to M&A over the next 12 to 24 months, we're open-minded about finding technology and talent to bring in. If you know something we should look at, we’d be glad to talk.

Ken, a question for you. A few years ago, the company embraced the Rule of 40 as a guiding principle to balance ACV growth and cash flow margins. What should investors think about regarding ACV growth versus profitability over time?

If we had to look at a mix of the Rule of 40 that would be more in line with our investments trending, it would be kind of more like 25% ACV growth and 15% margin. Naturally, we are not completely through the subscription transition yet, and we're not at 25% ACV growth right now—we're at about 22%. That's a way to think about where we might land with the Rule of 40 in the future.

We'll now take our next question from Vinod Srinivasaraghavan.

Just a quick housekeeping question first. Did you disclose the breakdown in cloud ACV this quarter?

The breakdown between Pega Cloud and Client Cloud? There’s an ACV table, and I will verify where that is, but we're trying to look at Client Cloud as a combined view of ACV because the two numbers become confusing when looked at individually. I'll get back to you on this in the MD&A.

And then I wanted to touch on the selling motion for Pega Cloud. Do you incentivize your sales force to sell it over Client Cloud? Do partners play a role in selling Pega Cloud as well?

Yes, partners can be a source, and we do have partners that bring us Pega Cloud deals. Generally, however, the client ends up wanting to sign the contract with us even if the deal was brought by a partner. We’ve occasionally done some indirect on Pega Cloud. We do not incentivize one over the other specifically because we believe the choice should be based on client needs. Client Cloud is often more sticky than Pega Cloud, as clients adopting it are likely doing so due to tight integration with their infrastructure.

Can you talk about how you see Project FNX impacting your longer-term gross margin profile?

Project FNX has already moved us onto the Kubernetes platform for new customers. We’re running production on what we call Cloud K. While Pega Cloud has been able to run on Kubernetes for some time, now we’re running Pega Cloud on Kubernetes as well, which gives us additional savings. Other elements of Project FNX will allow co-mingled multitenancy, among other benefits. FNX and this whole movement contribute to margin improvements as we progress, and they’re not done yet—we will continue to build on it.

If you think about the best-in-class multitenancy gross margins versus single-tenancy, we are trying to pull our margins in line with the efficiencies of multitenancy while retaining flexibility and some single-tenant benefits. That's the direction we're heading with our margins.

We'll now take our next question from Pat Walravens with JMP Securities.

A few quick ones for Ken here. First, I wanted to talk about the 2023 update you laid out during the investor briefing in June. How are you feeling about those targets? How should we think about the trajectory and shape of getting to those targets?

The targets we discussed at Investor Day—I'm feeling good about all of them. The only one that's an unknown is the mix between Client Cloud and Pega Cloud. We need to hit the growth number, and it won’t impact total subscription and total ACV—everything else is in line with what we discussed back in spring. So, while we don’t have a crystal ball for the mix, we need total ACV growth to continue to accelerate. As long as they come in, that’s what matters.

What are the key levers to drive growth and potential acceleration in total ACV?

We have a huge addressable market that is undisputed. Our solution set is best-in-class, and we have marquee clients. The focus lies in leveraging the relationships we have because we haven’t yet scratched the surface of penetration among our largest clients. Tremendous opportunity exists to accelerate ACV growth by deepening those relationships, expanding cases, and helping these clients achieve more with Pega.

Thank you. That does conclude today's question-and-answer session. I'd like to turn the conference back over to Mr. Trefler for any additional or closing remarks.

Thank you, and thank you to all of our investors and analysts. We are working hard on your behalf, and I want you all to know that. Please stay healthy, and I look forward to being able to see you all in person at some point—hopefully soon. Be well, everybody. Talk to you again soon.

Thank you. That does conclude today's conference. We do thank you all for your participation. You may now disconnect.