Pegasystems Inc Q2 FY2022 Earnings Call

Good day, and welcome to the Pega Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Kenneth Stillwell, CFO. Please go ahead, sir.

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q2 2022 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 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 2022 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 2022 earnings 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, 2021, 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'll turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Ken, and thank you to everyone who has joined today's call. This year has turned out to be an extremely volatile business environment. Our clients faced challenges related to the pandemic, labor shortages, the war in Europe, everything is causing global disruptions as well as, of course, rising inflation, high oil prices, supply chain challenges, economic and security concerns, and most recently, currency exchange headwinds. Some of these trends actually make the need for our software even more pronounced. In fact, we believe Pega is uniquely suited to help enterprises manage through such uncertainty. However, it does impact the market. And with the threat of recession looming, we've pivoted to lean more heavily on our Build for Change messaging. We've been updating our marketing and sales positioning, which you can see on pega.com. In an environment where efficiency and productivity are paramount, our low-code software platform for AI-powered decisioning and workflow automation helps demanding enterprises work smarter, unify experiences, and adapt instantly. So they can tackle what's next. At Pega, we're taking the volatility in the macroeconomic environment seriously. We're making cost management as much of a priority for us as it is for our clients, with a focus on operational efficiency and limiting increases to our cost structure. We've paid attention to make sure we're staying close to our clients by removing some of the layers that have crept in over the last few years. And by ensuring our talent is directly connected to clients, we believe will both improve outcomes and our long-term relationships. At the same time, we continue to focus on innovation to ensure we're able to provide the most advanced technology platform for our clients' needs today and into tomorrow. Ken will talk about some of the financial impacts on our business in a few moments. Now I'll turn to some highlights. Since we last spoke, we've continued to enhance our software and drive strategic partnerships to make it easier for clients to be productive and address their customers' needs with our market-leading Pega Infinity software. For example, we launched an updated component that makes it easy to embed Pega into Salesforce environments to further automate customer service workflow. Called Pega Process Extended for Salesforce, it's now available on the Salesforce AppExchange and allows organizations an easy way to drag and drop Pega Infinity workflow automation and AI-powered decisioning directly into existing Salesforce Lightning deployments. That makes the whole experience operate within users' familiar Salesforce desktop even as Pega drives the business logic and workflows. And we're also very excited about the low-code app factory concept. We're pleased to see our clients adopt our governed approach to low-code development. The goal is to have clients get the benefit of speed and collaboration capabilities of our development platform while ensuring they're building apps that can evolve, scale, and deliver value well into the future. It's very important that the governance capabilities are in place because over the years, people have often tried to drop in little systems to make improvements here, an improvement there. And frankly, large sophisticated organizations realize that that leads to just the next generation of technical debt, and they find themselves trying to rip out all the obsolete systems. By having a governed approach, we can share best practices and make sure that the right capabilities are baked into every low-code project and have them all hang together with this Pega app factory concept that brings business and IT together in support of organization-wide deployments. This is coupled with our Pega Process Fabric that makes distributed workflow applications tie together to create a single view of work that might be done for a specific purpose or that might be related to a specific customer relationship. The case study that Ford Motor Company presented at our recent Pega World is a great example of this approach. They have embraced best practices to deploy the Pega App Factory, which enables developers to create applications while following governance guidelines with support from an IT coach. They created a center of excellence and shared platform teams have joined forces to deploy the factory apps while working with Pega to develop best practices and alleviate IT backlog. Now another exciting development is that we've extended our cloud choice offering by expanding our multifaceted partnership with Google Cloud to help our joint customers accelerate their digital transformation. And we've also made the Google Cloud environment available on Pega Cloud as a fully managed as a service offering. We acquired Everflow, an innovative process mining software company whose intuitive software will enable our clients to uncover and eradicate in-process inefficiencies. These can often bog down organizations, and making them visible is key to improvement. Combined with Pega's market-leading AI-powered decisioning and workflow automation capabilities, this will evolve process mining beyond traditional static modeling to deliver real-time process optimization, what we sometimes refer to as true hyperautomation on an enterprise scale that will improve operational efficiency and customer experiences. And finally, we continue to receive industry recognition from leading analyst firms. In late May, Forrester named Pega a leader in the Forrester Wave for real-time interaction management. This is how you use AI to make decisions to provide the next best action to the customers. Out of 14 of the most significant players in this fraud category, Pega received top scores in the current offering and strategy categories and the highest score possible in 25 of 28 criteria, including the highest possible score in the market presence categories. Pega sets the gold standard for sophisticated enterprise deployments, its value-based approach and innovation track record earns Pega near-perfect marks across our strategy criteria. I'm also really pleased that just today, Forrester released its core CRM solutions report in which Pega received the top score in the current offering category as well as our highest score possible in 16 of 35 criteria. Out of four companies that were considered leaders, Pega received top scores in categories including CRM user productivity, assistance, guidance, next best action, digital sales, customer success, actionable insights, and omnichannel engagement. The report states, 'Pegasystems offers exceptional automation and process management within the CRM.' Pegasystems' Vision is one of an autonomous CRM, where automation offloads repetitive work, and AI assists users, increasing their efficiency and improving the customer experience. Pega uses real-time customer context and journey data to anticipate customer needs and proactively even preemptively engage. Reference clients stated that Pega provided 'a one-stop shop for our frontline team and praised the product's configurability.' I'm also very proud of the work our team continues to do to ensure Pega's creating and maintaining a diverse and equitable culture. Most recently, we were recognized as the best place to work for disability inclusion, scoring the highest possible score of 100 on the Disability Equality Index, which is recognized as one of the most robust disability inclusion assessment tools. Very proud of this recognition. Pega supports its people and communities by providing a safe and inclusive work environment. Congratulations to the many at Pega and around the world responsible for this recognition. Now you may have noticed that we put out a second press release, and I'll just talk for a moment about it. When there's noted interest in our technology over the years from organizations interested in leveraging our workflow capabilities to launch their own workflow-based applications into the market. To address this need, we announced a new product called Pega Launchpad, a cloud-based, low-code application development platform that will empower anyone to efficiently build and launch B2B software as a service application for commercialization. This is a long-term strategy that will be run as a separate commercialization unit, giving Pega new routes to market through an expanded third-party ecosystem without requiring the involvement of our sales force. We'll be working with a select group of early adopters for the remainder of 2022 as we prepare to roll out more generally in 2023. Once application providers are ready to bring new products to market, we'll work together through a revenue-sharing model that we expect. Now, I'm going to circle back to Pega World for a moment. I hope you're able to join Pega World in May. If you missed it live, I encourage you to watch the replay on pega.com. There are terrific sessions available, especially the inspiring client stories told in their own words. Through our virtual PegaWorld events, we have been successful over the last several years. I'm very excited to bring our live event in Las Vegas back next year as we get back to a more normal cadence of in-person meetings with clients and prospects. There's been a lot of change on that front. I attended Davos this past May in person and was able to see many of our most senior client contacts face-to-face. I mentioned a new briefing center being built on our last call. It's now fully open and has been booked with client and prospect meetings and has received a great reception. We're excited about the customers coming to visit us. So, in summary, we're operating in an environment of significant volatility. One that our software is uniquely suited to address, but one that obviously presents lots of pressure. We continue to structure our business and evolve our software to both address the needs of our clients and maximize our ability to respond quickly to changes in the market. Our transition to a subscription business and our loyal and stable client base are meaningful contributors to our ability to remain successful in today's business climate. We continue to be very excited about the significant opportunity in front of us and confident in our team to deliver on that opportunity. To provide more color on the financial results, let me turn it over to Ken Stillwell.

Thanks, Alan. To begin with, I want to share a few reflections on our first half results and our outlook for the rest of the year. Pega Cloud mix and the strengthening of the U.S. dollar negatively impacted our reported revenue and earnings per share. As a result, I'll speak a little more about currency this call than usual. As the U.S. dollar gets stronger, our recurring annual contract value, ACV, and our backlog balance denominated in other currencies decreases in value when translated into U.S. dollars, and revenue from other countries becomes smaller as well. A very big highlight for the quarter is Pega Cloud. Pega Cloud continues to be extremely popular. As a result, the Pega Cloud mix was much higher than planned, impacting our reported revenue and our earnings per share. Pega Cloud mix in the first half of 2022 was the highest it's ever been. For the first half of the year, Pega Cloud was 70% of new client commitments. We're focusing on operating leverage with an even greater amount of discipline to ensure our Rule of 40 target is achieved in 2024. As you review our financial results, you'll see that we've clearly been making progress on operating leverage primarily by slowing overall headcount growth in 2022. Although our constant currency ACV growth was 19% in Q2, we expect economic headwinds and crosswinds to negatively impact ACV growth for the full year. During our subscription transition, the most important metric to measure our success continues to be growth in ACV. ACV grew 19% in constant currency and 14% as reported year-over-year to $1.028 billion. The strength of the U.S. dollar significantly impacted year-over-year ACV growth as reported from Q2 2021 to Q2 2022. The currency impact of that year-over-year strengthening of the dollar on our ACV was approximately $40 million, with the majority of that impact hitting in Q2 of 2022. In fact, as the dollar strengthened so much that our recurring ACV balance decreased from Q1 2022 to Q2 2022 on an as-reported basis solely due to the strengthening U.S. dollar. It's important when measuring our business to look at a longer time horizon than one quarter. We've said we focus on total ACV growth for a full year and we're really in the 2022 cycle. That said, to date, our team has demonstrated over our history that it can produce ACV growth during difficult and uncertain times. It's important to point out that we do see economic uncertainty which could reduce incremental ACV growth in 2022, and we're managing the business accordingly. More on that later. Moving to backlog, we ended the quarter with $1.126 billion of backlog. The strength of the U.S. dollar had an approximate $57 million impact on our total backlog balance when looking at year-over-year growth. Turning to revenue, revenue for the first half of 2022 reached $651 million. Total subscription revenue reached $521 million. Subscription revenue is about 80% of our total revenue for the first half of 2022. Pega Cloud revenue is our fastest grower and reached just under $184 million for the first half of 2022. Total revenue growth in the first half of '22 does face a tough comparison, as many of you are aware. You may recall that we recognized over $30 million of revenue from one large deal in the first half of 2021, and the Pega Cloud mix was 15 percentage points lower. Therefore, year-over-year revenue comparisons are not as meaningful for the first half of 2022 because of those two items. We are currently in the final phase of our subscription transition, which we expect to complete in 2023 with the financial results normalizing for the full year 2024. Our Q2 results, like our Q1 results, showed additional signs of improving operating leverage and management of costs. Total gross margin was 72% for the first half of 2022. As I mentioned a few minutes ago, we plan to focus on cost management, ensuring that we reach the Rule of 40 target in 2024. Like all enterprise software companies, we're navigating through a high inflation environment, a global pandemic, and growing concerns of a global recession. In the face of these challenges, we've continued to grow ACV at a respectable pace to date. However, given the significant and unpredictable macroeconomic factors that I just outlined, we're going to provide a little more clarity on our view for the second half of 2022. We believe ACV growth for the full year will slow to around 16% in constant currency, about 5% less than we had planned for the full year. We want to make it clear this adjustment is to our 2022 outlook only. Moving to our revenue outlook. We see three key factors negatively impacting our revenue growth for the full year 2022. First, as we described in our investor session in June, our plan assumed Pega Cloud would represent a little more than half of our new client commitments in 2022. However, Pega Cloud has represented 70% of new client commitments in the first half of 2022. I know many of you will view this mix shift positively, but as we've said, a 20% or so increase in Pega Cloud could lower 2022 revenue by $80 million. And a higher-than-expected Pega Cloud mix would also cause ACV growth and revenue growth to diverge in 2022. That's because Pega Cloud revenue is recognized ratably typically over the contract period, which approximates three years. Second, the strength of the U.S. dollar is expected to negatively impact our full year revenue results. And third, we anticipate that the increasing economic uncertainty may elongate sales cycles and push some deals into 2023. If ACV growth slows as a result of this dynamic to 16%, as I mentioned, in constant currency in 2022, that would have an impact on total revenue as well. In total, we believe these three factors taken together could negatively impact full year revenue by approximately $120 million to $130 million. We do not expect a proportionate impact on earnings per share due to the cost-saving initiatives that I spoke about, where we expect to mitigate the revenue impact of over $100 million of that revenue shortfall by achieving significant cost savings. Naturally, there are a lot of moving parts in what I just said, which make it hard to forecast precisely. So, what are we doing to respond through all this? We will manage the business in a way to address the potential ACV growth slowdown and make up for more than half of the impact of our Pega Cloud mix shift. And that's a pretty impressive statement that we're making that we actually are going to end up being more efficient with the business based on the revenue and the ACV that we will achieve. Let me explain what I mean. We don't need to grow the size of the organization at the pace that we have in the last few years. We've added some pretty significant go-to-market capacity in 2020, 2021, and 2022. And we're going to focus the rest of 2022 on execution. We think this is the right time for us to reap the benefits of the significant investments we've made in hiring over the last few years. To remind everyone, we're targeting the Rule of 40 in 2024, and we will attempt to achieve the highest growth rate possible in getting to the Rule of 40. Our business is resilient, and I remain confident in our ability to deliver on our long-term strategy to be the leader in digital transformation. Let me remind you of some of the reasons that I feel that way. First, about 80% of our revenue is now subscription, thanks to our successful execution of the ongoing and near completion of the subscription transition. Our recurring revenue is supported by very high net retention rates. Second, if you look back to 2000, Pega has grown through every recession before, including some tough ones. And we've seen what clients stick with and what they invest in. Third, we serve the world's largest clients in core verticals such as financial services, insurance, healthcare, telecommunications, and government. In challenging economic times, unfortunately, small and medium-sized businesses are often the ones that struggle the most in the near term compared to larger enterprises that have strong financial profiles to withstand short-term shocks. Lastly, our digital transformation solutions feature unique capabilities and provide benefits that are critical to our clients going through transformation. Our core value proposition has proven important to our clients and helps Pega to grow through uncertain economic times. In summary, we've built a resilient business, and we will continue to provide best-in-class solutions to the world's largest clients even during tougher times. Despite the uncertain global economic outlook, it's an exciting time in Pega's history. We're wrapping up our subscription transition that we started in late 2017, and we're entering our next phase of growth as a company. As we wrap up the transition in the next year or so, we're confident that we will exit the transition as a much stronger business with more predictable revenue and return to cash flow levels that are even in excess of what we achieved before the transition. As a Rule of 40 company, we'll be capable of generating free cash flow each and every year because of the dependency and the reliability of the relationships that we have with our clients. Winning companies invest time and resources into reimagining their business model to unlock higher growth and greater profitability. The best companies successfully execute to make that imagination a reality. Now I'm really proud of the work our team and our over 6,000 employees have done over the last five years to transform Pega's business and unlock the company's potential. Thank you to everyone at Pega. As always, I'll be on the road and excited to see everyone face-to-face at a number of conferences over the next 45 days or so. I hope to get a chance to see many of you during the upcoming events. And one additional point, I'm very excited to reiterate what Alan said, which is I can't wait to see everyone at PegaWorld live next year. It's been too long. And with that, operator, please open the call for questions.

We'll now take our first question from Rishi Jaluria from RBC. Your line is open. Please go ahead.

Well, wonderful. I'm here again, thanks very much for taking my question. Maybe a few here to clarify and then, you know, appreciate all the details, especially around and what you're seeing. Maybe I want to start by talking about macro and a two-parter here. Number one, we would love to know what are you assuming, Ken, when you're talking about getting to 16% ACV growth exiting the year? You know, are you assuming macro stability with what you're seeing right now? Or are you assuming some level of deterioration from what things you're seeing? And then maybe the second part of that, there's obviously a macro impact on numbers already of constant currency from Q1 to Q2 on the ACV side. Some of your large-cap peers that have already kind of reported and talked about –

Sure. I'll address the first part, and then Alan can provide additional insight. We do not expect the market to remain the same as in the first half of the year. We believe sales cycles will lengthen, and buying patterns will become more constrained. By year's end, we anticipate that companies will be implementing cost management measures, which could work in our favor since we offer solutions, but it may also pressure overall purchasing behavior. Therefore, we don't expect things to remain status quo. We foresee a further downturn in the economic environment before year's end. However, we do not believe this will be an ongoing trend, though it's uncertain how budgeting for next year will influence the remainder of the year. This is why we felt it was important to clarify the risks we see, particularly regarding our annual ACV growth. We expect ACV growth to decline from 21% to 16%. To put this in perspective, our incremental ACV growth year-over-year will likely remain stable compared to 2021. We are still experiencing growth, but the percentage growth relative to a larger base will be slightly smaller. This is our outlook for the year. Alan, do you have any comments on the customer buying discussions you mentioned?

Yes, I believe Ken is correct in noting that the sales cycles are extending. However, I think the impact largely depends on the types of companies we are engaging with. The larger, more established buyers, who have historically been our primary customers and enabled a 20% growth rate in annual contract value, are now less affected by various pressures and more willing to proceed than mid-sized or smaller companies. Therefore, we are refocusing our efforts on building strong relationships with these critical organizations, which, based on what I've observed, are looking to reduce costs, enhance their workflows, and keep investing. This targeted approach will allow us to navigate the spending limits Ken mentioned, which we regard very seriously. We are not in a position to pursue significant growth at all costs in the latter half of this year and beyond; I believe the market will respond positively to our strategy. We have a significant opportunity to shape outcomes rather than merely reacting to the broader economic environment.

Alright. Great. That's really helpful. And then on the business. Maybe, I wanted to drill specifically into cloud CRPO. So, we saw that decelerate from 31% growth in Q1 to 14% in Q2. And even if we add back in six points of FX, that still gets us from a deceleration of 31% to 20%. Maybe can you walk us through what's going typically on cloud CRPO and maybe why we shouldn't be worried about that too much as a leading indicator of future cloud growth slowing down? And then one more follow-up, and I promise that's it.

We are observing a trend that clients are increasingly shifting towards consumption-based buying patterns. This means they are focusing on minimum commitments with variable usage, which ultimately leads to a slight decline in the duration of our cloud RPO. It's not a significant decline, more like going from three years to around 2.75 years. You can see this trend by looking at recent quarters. Additionally, the first half of 2022 was not particularly strong for Pega Cloud contract renewals, as these typically occur later in the year. Occasionally, there may be a few renewals in a quarter, but these two factors contribute to the somewhat confusing optics. Clients are not always committing to long-term contracts but may opt for shorter contracts with lower minimums, resulting in less being included in RPO for some of those agreements.

Got it. Helpful. And then last one, just on cloud gross margins. Obviously, been on a nice upward trajectory for the past really two years. But this is the first time we've seen a decline like this sequentially in a meaningful way into Q2, right, going from 70% to a little bit up 7%. I guess, was that FX? Or were there other factors that led to cloud gross margin declining sequentially? And how should we think about that going forward? Thank you.

Yes, that's a great question. The majority of our costs for Pega Cloud are incurred in the U.S. and paid in U.S. dollars. This results in a greater impact from currency fluctuations on our revenue than on our profits. In many other areas of our business, we have natural hedges because our expenses align with the currencies where our revenue is generated. However, our costs are more heavily weighted towards the U.S. due to our AWS contract being in U.S. dollars.

We'll take our next question from Steve Koenig from SMBC Nikko. Your line is open. Please go ahead.

Thank you for taking my questions. I will ask one question and then a follow-up. First, I want to congratulate you on the Forrester evaluation, which seems to be a great confirmation of your technology leadership. My first question is about the financial aspects. There are a few moving parts to consider. Regarding Pega Cloud revenue, the sequential revenue growth was quite low, and I'm curious how that correlates with the higher cloud mix. Additionally, RPO bookings experienced a significant decline year-over-year, and I would like to know how surprising that was regarding the weakness in new client commitments compared to your internal expectations. Also, how much of that decline was due to a lighter renewal schedule? Finally, I have one follow-up question for Alan. Thank you.

Yes, Q2 had a very light renewal schedule, and the mix of Pega Cloud was affected by currency fluctuations similarly to our overall revenue. While the revenue distribution by geography isn't precisely aligned, it's close to our overall revenue regarding the currency impact. The RPO was influenced by currency effects during a lower renewal quarter in Q2, and our net ACV growth in Q2 was not as robust either. Consequently, our ACV growth in Q2 was weaker than in Q1 due to the combination of a smaller renewal quarter and currency effects. That summarizes the situation with RPO.

Okay. That sounds good. Maybe we'll follow up a bit more on the callback. Alan, regarding Pega Launchpad, that's really interesting. I know you've been working on much of this for some time as part of the Phoenix initiative. Could you provide some details on the milestones for establishing a vibrant third-party marketplace, both technically and in terms of business? Any thoughts on monetization? Does Pega pricing need to be more transparent? Are there any early alpha customers or partners you can discuss? Thank you very much, and that concludes my questions.

Sure. We have been focused on many of these elements for a while as part of the Phoenix initiative, which plays a significant role in the technology we introduce and bring to market. The launch pad concept recognizes that some organizations want to create intellectual property and bring it to market, often with a specific workflow aspect. Frankly, the platforms we have observed were not well-equipped for that purpose. We have engaged with several individuals and companies about this and wanted to start discussions. We felt the best approach was to announce publicly that we are ready to begin conversations with early adopters. I will be able to provide more detailed answers after we progress another 90 to 120 days into this. While I am not ready to share more specifics right now, my enthusiasm for this opportunity is strong, and I find it very exciting.

We will now take the next question from Pinjalim Bora from JPMorgan.

This is Noah on for Pinjalim. Thank you for taking the question. Can you explain what you're seeing in terms of demand from public sector customers? And just any color on the rate of new IT engagements within the public sector would be helpful. Thanks.

Yes, I can talk to that. I think that public sector has been pretty shaken by the pandemic. A lot of the solutions that have gone into public sector to just make them work, particularly at some of the large governmental organizations we do business with. We are widely seeing to be scotch tape and bailing wire. So there is a, I think, a healthy appetite in large agencies to continue and even accelerate the workflow automation that we already do for several of them going forward. So I think the demand in the public sector will continue to be strong. Having said that, as we all know, the public sector is not a place that tends to buy rapidly, and they tend to want to buy very much on a consumption-based model. So you don't get the big multiyear deals with lots of things sort of on the come based on expectations. It really is a line of business that I would describe as sort of building an engine of success that, as you develop greater confidence and a greater footprint, it builds on itself. But the market opportunity there is huge, we are very much going to focus on what I would describe as federal and large state contracts here. I think that plays to our strength and that also plays to the people that will be buying.

We will now take the next question from Vinod Srinivasaraghavan from Barclays. Your line is open. Please go ahead.

Thank you for taking my questions. I would like to reflect on the past and discuss buying patterns as we entered the COVID period and the second quarter of 2020. I am curious if the current situation resembles that time and when you noticed improvements in sales cycles and more meaningful customer reengagement back then. Are you observing any early signs that a similar trend might occur now? Thank you.

I can start on that one. I remember those days clearly. The difference between Q2 2020 and Q2 2022 is significant. In Q2 2020, we were uncertain about the future. There were concerns that the situation could lead to a global economic shutdown, affecting people's access to essential items. We were in a state of panic, unsure of the duration of the crisis, and there was considerable anxiety about what we were facing. I recall the drastic rise in unemployment claims during that period. In contrast, today's environment reflects a more typical economic reset. People understand what to expect; they need to manage their budgets, slow hiring, and consider projects that will optimize their businesses. This kind of adjustment occurs every five to ten years, depending on the recession cycle. I don't think this situation is comparable to Q2 of 2020 due to the significant confusion that existed in the market for several months then. From my perspective, this time around, people are more aware of what lies ahead. They may not know the extent or duration of the challenges, but we've experienced recessions before. That's my view. Alan?

Yes, I would agree that the atmosphere back then was much more of confusion, who knows what's going to be, how long it's going to be for, will we be able to get the right staff to support the business at all? There were a little burst of, 'Oh my God, we've got to automate something,' but there was an incentive to it that people said, 'I've got to do it in 10 days or a week.' And by the way, we've delivered some pretty amazing systems in that time to support things like the Paycheck Protection Act. I was just talking to one of our very large banking customers who said that they'll never forget what they were able to do in a week with our system when they were just trying to hold on. The time now is just a lot more rational, right? People expect dimensions are going to fall into just how long it’s going to be tight. People are extremely interested in the low-code piece and are extremely valuable because they want to be able to continue to run their systems without necessarily relying on the same depth of engineering talent that they had come to depend on. So I would describe this as a much more, frankly, reassuring time than if you go back to the point where every week was a new terror.

Got it. I appreciate some of the color on that. And then just one follow-up for me. Can you maybe speak to just kind of the sales execution during the quarter, how you kind of feel about that? And also, are you seeing any customers ask for more pricing concessions or more flexible payment terms given kind of the macro environment? Thank you.

I'll address the second question first. Our core customers, who we are focusing on moving forward, do not require payment concessions. While there will always be requests, that is not the segment of the market we are concentrating on. From a sales execution perspective, we have experienced significant changes in our go-to-market strategy, especially during the second quarter. We are currently in the midst of this transition, which likely affected our ability to consolidate our efforts. I believe we have mostly completed what I refer to as Phase 1 of change management, which involves understanding our structural and positioning goals. There is still much work ahead in the coming quarters. However, we are committed to becoming a cost-effective growth company, focusing on managing expenses. This shift is now ingrained in the fabric of the organization, particularly within the go-to-market team. I am confident that we have a viable plan moving forward, one that aligns well with our experience in this field. We recognize that demand exists among our customers, who especially appreciate how our software can uniquely assist them in navigating their challenges. I feel optimistic about this outlook. The first half of the year was quite volatile, with significant management changes occurring in the last five months. This undoubtedly impacted our second quarter performance. We are not satisfied with these results and are dedicated to improving them; we do not consider a 16% outcome acceptable going forward, even if it may be a realistic expectation given our current circumstances.

I'll add one piece of color. I see a lot of client interactions, and I don't observe clients trying to extract the same value from Pega at a lower cost. Instead, clients are focusing on managing cost increases due to inflation. The consumer price index is significantly higher now, and there is an expectation that technology companies will see some increase in annual costs. Clients are primarily focused on managing these increases, just as we are, because we anticipate increases to help offset our own cost rises related to our team members. This is a key area of focus, but we haven't seen a general reduction in spending.

We will now take the next questions from Kevin Kumar from Goldman Sachs. Your line is open. Please go ahead.

Hi, thanks for taking my questions. Alan, given the macro environment, are there any changes in the types of use cases across the customer base, whether that's customer engagement or customer service, other areas of automation; curious where you're seeing the most appetite?

In the real-time interaction management space, which focuses on AI-driven decision-making, we have shifted our focus from cross-selling and upselling to retention due to recent economic changes. We engage in effective retention strategies, including compassionate collections, where we assess how to optimize collections for businesses. This reflects the current recessionary trends we have experienced before. Similar discussions are gaining attention now. In terms of workflow automation and transparency, managing a distributed workforce that may not reconvene is crucial, and we refer to these solutions collectively as the process fabric to maintain organizational cohesion. These use cases resonate strongly with the current times and often involve substantial systems that develop significant value over time.

That's helpful. Thank you. And then as you integrate the Everflow acquisition, how has customer traction been there? And how should we think about ACV uplift on deals where process mining is used?

I think process mining is primarily a vehicle to be able to make the customer more effective at deploying your software. I think that more than a very significant increase in ACV on the deal, I think you will see an acceleration of consumption and use. And that leads to, in effect, larger parts of the business being in a position to cost justify and rationalize the purchase. So I view it as contributing to ACV, more by helping promote volume than by kicking the prices up 20%, right? It's discovering the opportunity and optimizing the opportunity, which lets you go bigger, particularly these big companies.

And just to clarify, just to make sure that's crystal clear, we are not in the business of selling user-based licenses as our exclusive go-to-market where you keep price up ticking every single feature function. What Alan is talking about is clients will get more value by putting more automated transactions through our system, and that's the way the ACV goes up because they're paying on a kind of a consumption-type model. That's kind of the connection there just to make sure that's clear.

We will now take the next question from Joseph Meares from Truist. Your line is open. Please go ahead.

Thanks for taking my question. The first question, I was if you had already said this in the prepared remarks, but could you just give us some clarity on the cost initiatives that you're talking about? I think you said it would be more than half of the decline caused by the Pega Cloud. But could you just clarify that?

Yes, I understand that the wording can be difficult to follow at times. We expect that the combination of three factors—Pega Cloud, mix, and currency, with currency being the least significant—along with the impact of our ACV target, will cause revenue to decrease by approximately $120 million to $130 million from our initial expectations. Some may think this will directly affect EPS by the same amount, but that's not the case. We believe we have the necessary staff to navigate through 2022 and achieve our 2023 goals. By maintaining our current cost structure, we anticipate recovering over $100 million of that revenue decline. While we may not fully close the gap, we are signaling that we can nearly get there. To clarify, we will offset the ACV decline and adjust for currency impacts, and we expect to cover more than half of the loss from the cloud mix. Collectively, these factors will contribute to mitigating over $100 million of the revenue shortfall.

That's perfect. Super helpful, Ken. I appreciate it. And then just as a follow-up. Last quarter, you spoke about several new products, including enhancements to the Pega Customer Decision Hub and voice AI and messaging solutions for customer service. Just curious if you have any early customer feedback on those? Any positive stuff you can point to there? Thanks so much for taking the questions.

Yes. So we continue to get excellent feedback on the Customer Decision Hub, that's the real-time interaction management piece that I was talking about that Forrester just landed. That continues, I would say, to be by far the industry-leading product in that segment. The new capabilities are being widely enjoyed. The voice AI is rolling out slowly. We've got some pilot work that we've been doing. I think it's enormously exciting. But to be candid, I think that a lot of organizations are just trying to stabilize that part of their business. If things get a little more normal, I think that's going to pick up. But right now, there's just an enormous amount of what I describe as contact center exhaustion, where people who are running those things are just trying to deal with making sure they've got the staff and that they're able to just keep them running. So it's probably going a little slower than I'd like, but that was never going to be a big part of our number for this year.

We will now do the next question from Mark Schappel from Loop Capital. Your line is open. Please go ahead.

Hi, thanks for taking my question. Ken, starting with you, with respect to the macro, just to be clear here, are you saying you're seeing lengthening sales cycles and project delays in your business today? Or are you just trying to get ahead of the curve with your comments?

I would say I am seeing a little bit of lengthening sales cycles, but nothing I would say material to lead me to an absolute conclusion. I am more trying to get ahead of where I think the market will be for the rest of the year.

Okay, great. And then, you know, with respect to the sales cycles, are you seeing that in any particular geography more so than others?

Europe, I can speak to, but certainly Europe is much closer to the frontlines of the conflict. The situation in Ukraine is affecting them more seriously, and they are seeing issues like energy or resources and food. They are much more disrupted than certainly the United States is and even a bit more so in APJ. Customer mood in some of those countries is hard to gauge.

I just going to say customer mood and some of those countries is just hard to get their attention.

I understand. And then Alan, final question here. It's around the launch pad. I believe in your prepared remarks, you mentioned that the product would be run as a separate commercialization effort. I was wondering if you just go into a little bit more detail of what exactly that means?

We have identified a couple of entrepreneurial individuals from our existing team to form a primarily virtual group. We will keep this initiative separate from our current go-to-market strategy and messaging, treating it as a distinct product. We will leverage our extensive experience to inform this new offering, which will be marketed through a partner-sold channel involving organizations with the intellectual property they wish to sell. My priority is to protect our core business from any potential disruptions, allowing us to concentrate on maximizing our performance this year.

We will take the next question from Joey Marincek from JMP Securities. Your line is open. Please go ahead.

Thanks so much for the question. Alan, would love to hear more about Google Cloud? I know it's early. But how is that partnership progressing thus far? And maybe what are your early learning? And then one for Ken? Can you give us an update on net retention? How is that metric trended? And maybe how would you think about it on a go-forward basis? Thank you so much.

Sure. So the Google relationship, I would say, is terrific. You know, we've been able to work with them to stand up this capability. I think being able to offer customers the ability to use Amazon credits or Google credits that they may have committed to has excited customers. So that relationship is deep and very, very positive. And, you know, I'm also pleased to say that Google is a client, which is wonderful when a company like that decides that they want to use your stuff internally, so now, I believe it's going to work out very, very well. You know, Amazon has been a terrific partner, and we love working with them also. But the reality is, as they move into, say, the medical field as they recently have done in a greater quantity, and as they move into retail, that means certain of the very large clients that we want to sell to have less attraction to using them as a platform. It doesn't impact visible to a customer whether they're running the Pega Cloud on Amazon or on Google, but some companies have their own standards and their objectives in that regard. Now we're just in a position to give that extra dimension of client choice, which is always good.

So our net retention, that's a really good finish to the questions, because it's one that we haven't really touched on. Directionally, I've always talked about, if we have 20% ACV growth that 15% of that 20% would be with existing clients and the other 5% would be net new logos. That is a directional number. But that is not far off. When you think about us, our ACV growth declining by some percentage, the majority of that decline would be our expectation of getting ACV from net new logos. Right? So I think our net retention number is not going to decline much with our overall ACV declines because that is our bread and butter. That is actually where we're going to put our capacity. That’s where we've always received the majority of our bookings. Hence our focus is going to be really heavy there, especially in any type of less than certain economic environment. You should always stay close to your clients because they’re going to deepen their relationships with existing vendors, that is just the trend. So I think our net retention rate will hold pretty steady to what it's historically been, maybe like drop by a percent or so. But not much. What will happen is we will probably, you know, just being pragmatic we will chase new logos less.

And with that, I think we're at time. I'd like to thank all the folks who participated or listened to the call. You should know that we're working very hard. We're taking the needs of our shareholders very seriously. I'm hopeful that we'll be able to report some good things in a quarter. Thank you very much.

This concludes today's call. Thank you for your participation. You may now disconnect.