Pegasystems Inc Q4 FY2022 Earnings Call

Good day, and welcome to the Pegasystems Fourth Quarter and Fiscal Year-End 2022 Earnings Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Kenneth Stillwell. Please go ahead.

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q4 and full year 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, forecast, guidance, likely and usually or variations of such words or 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 the forward-looking statements are contained in the company's press release announcing its Q4 2022 and full year 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, 2022, 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 the 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 everyone on today's call. I'm proud of how our team adapted, leveraged our strengths, and executed in 2022, demonstrating exceptional resiliency. We ended the year with 16% ACV growth, right where we said we would be, despite multiple significant distractions and challenges. We are making progress to become a Rule of 40 company, which will drive greater value for our shareholders and opportunities to further invest in our business, technology, and our people. Our results reinforce the effectiveness of our strategy to target customers where we know we have tremendous opportunities for growth. Ken will discuss in more detail later in the call. The market dynamics here are very positive for us in some key ways. Digital transformation continues to be a driving force for our clients, and we expect it to be even more important in 2023, given the economic indicators. The uncertain environment we are in and we are going to continue to focus on Enterprise automation, which is top of mind for clients looking to optimize their investments, increase efficiency, and improve effectiveness. According to IDC's 2022 Worldwide CEO survey, the number one skill CEOs think will be most critical to their success over the next three years is digital know-how. At the same time, there is a growing scarcity of developer skills, which helps drive increasing use of low-code and no-code solutions. According to the latest forecast from Gartner, the worldwide market for low-code development technologies is projected to total $27 billion in 2023, an increase of nearly 20% from 2022. And IDC projects that by 2025, the majority of application developers worldwide will be low-code or no-code developers. This theme is consistent with what we are hearing from clients. I recently came back from Davos, where I met face-to-face with CEOs of some of our largest and most strategic customers. They told me they are focused on digital transformation as key to success, and this will be especially true in what they expect will be a challenging year. They know they need better and faster ways to do things, driven by the economic environment and scarcity of resources, and Pega is perfectly positioned to leverage these dynamics. We have a long history in this space and a clear strategy to focus us this year and beyond. Our strategy is very much vested in our technology. Pega technology provides the most powerful and scalable low-code platform for AI-powered decisioning and workflow automation, designed to help clients maximize value, simplify service, and boost efficiency, while being adaptable to change. Our product leadership is recognized by industry analysts, leading to dramatic successes with many of the world's most recognized and sophisticated organizations and their partners. Our Cloud innovation has accelerated adoption, and we have made tremendous progress on modernizing our clients who now more than ever are able to make use of our latest advancements. We are strengthening deep strategic relationships with our clients and their trusted partners, and we believe they are more likely to consolidate their technology choices with proven and trusted providers in this uncertain environment. Finding accelerated value for these clients will translate directly to significant growth for us. We are building a healthy, agile, and efficient organization to work closely with our clients and inspire innovative ideas and creative solutions to their biggest challenges. Now going into the year, we do expect it will be tough based on all the economic indicators, and we have taken steps and planned accordingly. As we announced in early January, we had to make some tough decisions to help set us up for both long-term and short-term success. These changes were focused on our go-to-market organization, driving alignment to improve our go-to-market operating model, enabling greater efficiency, and sharpening our client focus, especially where our historical investment outpaced our growth. Nearly all of the changes have been completed. There are some markets that we are working through evaluations in adherence to local regulations and processes. I know this is a challenging time for many whose roles are changing or being eliminated, as well as those saying goodbye to colleagues; we care deeply for them. We are working to take great care to support those who are being laid off, in keeping with our values. Like many other companies, we are planning for more conservative growth in 2023, which Ken will talk about more later in the call. Our overall approach and strength will continue to serve us well as we go beyond this year and into future years, where we will continue to adapt. Whether our clients are focused on rapid growth or cost cutting, we have the technology and the approach to do either as we have shown over the years. I am also excited to see that our subscription transition is nearing completion, and you can see the related impact on our financial results and projections. Combined with the organizational changes we are making, we are well positioned to be a significant cash generator over time, giving us the flexibility to invest in growth opportunities for the business. Pega has always focused on innovation and providing the most innovative and effective solutions for our clients, which has been central to our success. In 2022, we continued to enhance Pega Infinity to give clients the best low-code platform in the industry. Some highlights included launching a new version of Pega Infinity, allowing organizations to develop apps faster, create smarter workflows, and improve experiences for customers and employees. We continue to focus on Pega Cloud and have significantly increased adoption. Our global operation center, which uses extensive workflows built on Pega Infinity, can bring automation, availability, reliability, and scale to our cloud operations. We see this as one reason clients are choosing Pega Cloud over running their own cloud because they can see how well we can perform. We introduced new low-code templates, forces, and services to help organizations improve productivity while reducing strain on IT teams, all while maintaining good governance. With the demand for professional developers exceeding current availability, organizations want to tap into citizen developers to get work done. However, citizen development can also create silos and increased risk and costs if there isn't proper governance or if the tools are not sanctioned or supported by enterprise IT. Many of the lower-end low-code tools in the market today contribute to that challenge. Pega's low-code factory approach empowers citizen developers while providing technology support and governance to automate the enforcement of best practices, ensuring security, scalability, and maintainability. We have also enhanced our robotics capabilities to make it easier for users of any skill level to quickly build robotic automations that enhance business processes when robotics makes sense. Additionally, we acquired Everflow to add intuitive process mining capabilities, creating what we believe is the industry's most complete hyper-automation solution, enabling Pega clients to uncover and fix hidden processing inefficiencies that could otherwise bog down an organization's operations. We are also tracking interesting elements regarding recent generative AI technologies and how they can be integrated into our offerings to enhance them further. We are exploring model-driven approaches to address business models dramatically. All of this plays into the historical strengths of Pega. Pega is well-positioned to leverage these strengths. We anticipate exciting news to share at PegaWorld in June as a result of this work. Additionally, we announced Pega LaunchPad, a new cloud-based low-code application development platform, designed to empower users to build and monetize new business-to-business SaaS applications. This has the potential to provide new revenue streams and tap into an interesting new market for us. Our goal is to sign up several early adopters during 2022 in anticipation of launching in 2023, and we are right on track with where we want to be. I would like to touch on some client highlights as this is ultimately what drives our success. The innovation for innovation's sake has never been our strategy. Whether homegrown or acquired, we've always focused first on how a new feature, technology, or product would support our clients' goals and contribute to their success. This is why we continue to see impressive results from our clients and why so many are willing to publicly discuss how they leverage our software. For example, several of our banking clients recently won awards for their use of Pega software, including NatWest for being the best banking tech provider for their use of 'Know Your Customer' and Pega customer lifecycle management solutions. The Invoice Banking Group received the award for the best use of IT in retail banking for their automation and streamlining of processes for customer credit cards, all built on Pega Cloud. More than 40 clients have signed up to share their success stories at PegaWorld this year in June, including Roche, Wells Fargo, Virgin Media, and the FDA, just to name a few. We are thrilled to be returning to Las Vegas for our first in-person PegaWorld in four years. In addition to many clients, we anticipate over 30 major partners signed up as sponsors, including Accenture, EY, Capgemini, and others; they will be demonstrating their services and solutions along with our latest technology in our Innovation Hub. Please check out the PegaWorld website, register, and join us live to hear these stories and see the amazing technology firsthand. I'm also excited to see a steady stream of our clients coming from Amsterdam and Australia visiting our new executive briefing center in Cambridge for in-depth, highly strategic conversations. In summary, I'd like to state that we have shown our resiliency and ability to execute in challenging times. I am excited that our transition to a subscription business is nearing completion and the positive effects it is having on our results. We are on pace to become a Rule of 40 company as we exit 2024. We are in the right space, with the right heritage, capabilities, and strategy at the right time to leverage the significant opportunities ahead, and we have the right team to deliver on that opportunity. To provide more color on the financial results, let me turn it back to you, Ken.

Thanks, Alan. Nothing brings more stability to revenue, profitability, and cash flow than our recurring business model, especially in times of economic uncertainty. That's the major reason we embarked on our subscription transition five years ago. Our execution has been strong, thanks to the hard work and resiliency of our team in close collaboration with our clients and partners. Over this five-year transition period, we have achieved a nearly 250% increase in our annual contract value and more than doubled our subscription revenue, which in 2022 topped $1 billion. Subscription revenue now represents 81% of Pega's total revenue, up from just around 50% a few years ago, with most of the remaining revenue coming from professional services. Our subscription model helps us build a more resilient business, improve profitability, and scale through operating leverage, especially with our high client retention rates and massive client expansion opportunities. Growth in annual contract value is the key growth metric to measure our business momentum. During the transition, we almost exclusively focused on ACV because of its critical importance. So let's talk about our ACV results. In Q4 2022, annual contract value increased 16% year-over-year in constant currency and 13% as reported, reaching $1.1 billion. Our ACV growth was driven by our go-to-market strategy focused heavily on cross-selling and upselling to our existing clients. Pega Cloud ACV reached $455 million, an increase of over $90 million. Over 60% of our new client commitments were from Pega Cloud deals in 2022. Another important metric to measure our success during the subscription transition is the growth in remaining performance obligation or backlog. Total backlog reached $1.36 billion as reported. As highlighted last year in our earnings call in Q4 of 2021, our subscription license backlog was unusually high, resulting in a tough comparison this year. Focusing just on subscription services, which includes Pega Cloud and maintenance, backlog grew 13% year-over-year, in line with our reported ACV growth rate. We are in the final months of our subscription transition, and our 2022 results demonstrate that we exited the year with improved profitability, as we expected. Our non-GAAP EPS reached $0.72, an increase of over 200% year-over-year, driven by more disciplined expense management, especially in sales and marketing. In fact, total sales and marketing costs were down slightly year-over-year. You'll hear later that we expect to see another significant increase in profitability in 2023. Second, Pega Cloud gross margin improved approximately 300 basis points to 70%. This improvement was driven by increased scale as well as innovation in our cloud architecture that helped increase automation and further drive efficiency. When the subscription transition is complete, free cash flow generation will start to normalize, a critical step on our path to becoming a Rule of 40 company as we exit 2024. Recall that we define Rule of 40 as the combination of ACV growth and free cash flow margin, adjusting for other items outside the ordinary course of business. The reason I say we will become a Rule of 40 company as we exit 2024 is that our bookings are skewed toward the end of the year, resulting in cash collections that often bridge into the following year. Once we exit 2024, our cash collections should normalize. That said, you should expect to see significant improvements in free cash flow in 2023 and 2024. Moving to our fiscal year 2023 guidance, we provide annual guidance at the beginning of the year, and do not typically update guidance. For the last several years, we invested aggressively in sales and marketing to accelerate our ACV growth rate, and our guidance philosophy reflected our belief that these incremental investments would result in significant ACV growth acceleration. As we considered our 2023 guidance approach, we looked at world events that suggest 2023 will be a tougher, less predictable year for everyone. Our 2023 guidance reflects this view. We know from experience that during uncertain times, focus is crucial, and we believe the changes to our go-to-market strategy will work well in the current environment. In January, we announced a 4% reduction in our global workforce. We expect that action to result in over $75 million of net savings versus our original spending plan, and we are focused on improving our sales efficiency by further selling into our existing client base, made up of the largest and most respected global brands. We are pursuing new clients selectively, often landing new clients through existing client recommendations or referrals from industry analysts. There is a reasonably high degree of uncertainty in this market, and we assume there is a risk that enterprise software companies, including Pega, could experience longer deal sales cycles, lower close rates, and deal value compression. Given these risks, we've decided to factor this into our guidance. So let's get into the guidance numbers for full year 2023. Total ACV is expected to grow 11% to 13% year-over-year. Our execution is aimed at achieving the Rule of 40 by 2024. We believe total revenue will be approximately $1.4 billion, and we expect non-GAAP earnings per share of about $1.50. Given our focus on increasing cash flow, we've added a new guidance metric this year: free cash flow. We project free cash flow of $150 million in 2023. From where we stand today, these are our best estimates for what we will deliver to our shareholders in 2023. A reconciliation of our GAAP and non-GAAP guidance is contained in our earnings release. We also thought it would be helpful to provide additional guidelines on how to think about modeling our business in 2023. First, we believe Pega Cloud will represent between 60% and 70% of new client commitments in 2023; a 1% shift in the projected Pega Cloud mix would impact recognized revenue for the full year by approximately $3 million. Second, 2023 is a more typical year in terms of renewal volume. Our renewal portfolio is skewed to Q4 of 2023, likely resulting in a more significant portion of our ACV growth and revenue occurring in the second half of the year, with a larger amount of our collections straddling Q4 of 2023 into the beginning of 2024. Third, given that term license backlog was unusually high at the end of 2021, we expect term license revenue for Q1 of 2023 to be more consistent with the historical pattern for first quarters. Lastly, we expect our sales and marketing expenses to be higher in the first half of 2023 due to PegaWorld, our annual customer conference being held in person this year. Regardless of the seasonality of our business, we think the first half of 2023 will likely be slower due to expected economic softness and fewer renewals. Our annual Investor Day will be held during PegaWorld from June 11 to 13 at the MGM Grand in Las Vegas, Nevada. Please mark your calendars for this event. I look forward to seeing many of you there, where we'll share updates on our go-to-market strategy, technology, and financials, including our long-term model, along with a Q&A session. In conclusion, we are driving toward becoming a Rule of 40 company, resulting in significant increases in free cash flow generation, while providing opportunities to invest in our best-in-class technology, clients, and workforce. I look forward to seeing many of you in early March at several upcoming investor conferences.

And we will go first to Kevin Kumar with Goldman Sachs.

It's pretty solid results here, particularly on ACV. I guess how much of that resiliency is just a function of the sales reorganization you did last year? And are you seeing the efficiency improvements that you're hoping for?

So Kevin, I'll take the first part of that. It's not surprising that we expect to start seeing better engagement with our target organizations and existing clients, as there is so much more focus and capacity within the company around those clients. Those clients are precious to us, not only because they generated $1 billion of ACV, but also because there are tens of billions of dollars of opportunity within those clients for the future. So I do believe the recalibration to the core of our client base was helpful. I wouldn't claim victory on efficiency and go-to-market at this stage since it's too early, but I can say we do see a connection between efficiency and engagement with those specific clients. Alan?

Yes, we are still in the process of implementing these changes. The good news is that the changes have been architecturally made. The allocation of resources to organizations and the reallocation of resources to roles that make the most sense have been announced as part of the kickoff of the year. We spent a good part of last year determining the best course of action, as this represents a significant shift in our go-to-market. I'm seeing evidence from both increased engagement with staff and response from clients that this has been very positive, and I believe it will lead to the results we expect.

I have a question about the term license revenue in the quarter. It appears that this number was significantly higher than what analysts were expecting. Can you provide any insights on whether there were pull-forward deals, or if this is simply a return to a typical pattern for the fourth quarter?

Yes, good question. The last point you made is absolutely true. At year-end, there tends to be a little bit of a higher Client Cloud versus Pega Cloud mix in Q4, and that was definitely a factor. Last year, we had several deals go into backlog at the end of the year, which impacted revenue in Q1 of 2022. This year, the timing of some of those deals happened to yield revenue in Q4 instead of Q1 of 2023. Thus, the mix was not unexpected, and the timing of it was just due to whether a deal hits on December 31 or January 1.

And we'll go next to Steve Enders with Citi.

I want to clarify a little on your outlook, particularly regarding the macro environment. If I'm interpreting correctly, it seems you haven’t seen much impact regarding deal cycle slowdowns, and I think you've embedded that into your guidance. Is that fair to say? Additionally, how should we view some of the other underlying assumptions you're considering there?

Well, reflected in the selection of 11% to 13% is kind of the guidepost. It's a bit challenging because there are impacts I'm seeing that the conversations with other CEOs are somewhat down, but it’s not about us, particularly with larger, more sophisticated companies. The economic impact is more pronounced on the SMB market, which we consciously shifted away from last year, though we may have wasted some resources on it. I think that decision is providing us greater resiliency than many other firms in this market.

Additionally, in periods of budget constraints, there is a tendency for client spending to concentrate with known vendors or value propositions. This also plays into our strategy if that occurs.

That's helpful context. Regarding competitive dynamics, have you noticed any shifts in market activities? I know that one of your competitors has been releasing some negative news lately. What impact is that potentially having?

I'm not going to rise to that level, tempting as it may be. The competitive dynamics remain similar to what we have seen. However, I see a belief among larger companies that there is significant risk associated with creating new technical debt with low-code and no-code approaches that might involve multiple standalone systems. This idea of having an enterprise app factory—an architecture empowering citizen developers while looking to maintain efficiency—has a lot of appeal. We've been discussing this approach uniquely for the last couple of years, which will give us a competitive advantage.

And we will move to our next question from Rishi Jaluria with RBC Capital Markets.

This is Richard Poland on behalf of Rishi Jaluria. On expansion with existing logos, I believe you've previously mentioned that approximately 75% to 80% of your growth comes from existing logos. Moving forward to next year, how should we consider that mix? Additionally, what upsell drivers are encouraging as we head into the next year?

You're correct that a few years ago, 75% to 80% of our ACV growth came from existing logos. Now, if we consider the last couple of quarters and project for 2023, I expect that number will exceed 90% of our ACV from existing clients. This doesn't mean we won't pursue new logos, but in 2023, those new logos will be targeted and, often, smaller deals compared to upsell and expansion opportunities with our existing clients.

Regarding logos, we generally do not consider it a new logo, even when we enter a new division of a major company we already do business with. It’s encouraging that we're seeing increased engagement with significant companies despite travel restrictions, indicating a move toward spreading our influence in their businesses. This reflects our strategy to become trusted advisers rather than simply transactional providers, which is yielding a strong response from clients.

As a follow-up, regarding some of the ISV and global system integrator partnerships, it appears relations have been improving in recent quarters. I know Pega LaunchPad has played a role, but can you provide insight into your strategy with the partner ecosystem moving forward?

The shift in relationships with our partners regarding the new strategy aligns with their focus on significant customers. We've stressed the importance of our account teams meeting directly with key partners at major organizations, which is generating enthusiasm from partners and our staff. While we don’t expect LaunchPad to significantly contribute revenue in 2023, we are very excited about its potential and the increased interest from many companies, much higher than we are currently in a position to service.

And we'll move on to our next question from Pinjalim Bora with JP Morgan.

On quarter. Ken, just one question on the ACV growth guidance. Can you help us understand your approach to building that guidance? What assumptions are you baking in? Are you using pipeline data and the close rates from Q3 and Q4 for projections, or have you adjusted those?

Sure. A few factors are considered. Naturally, we look at our pipeline, focusing on our existing clients. We make adjustments to the close rates based on specific client engagement and potential renewal events. We also evaluate specific AEs and their momentum to build our projections. This is not a general statistical analysis; rather, it is based on the specific client relationships and probability adjustments that make up our pipeline.

Could you talk about the changes you made and the associated risks in sales for this year? Additionally, I see sales and marketing expenses were down in Q4. Where are you observing efficiency gains beyond the changes?

We made some cost calibrations in the middle of the year that came into play in Q4, resulting in unanticipated savings. While those reductions won't impact Q4, they will affect Q1 and beyond. The main efficiency driver in sales and marketing comes from refining the ratio of non-primary quota carriers to primary quota carriers in target organizations. This ratio expanded when we were more focused on acquiring new logos, but we're now honing in on ensuring account executives are the quarterbacks for their accounts.

If our account executives and teams are concentrated on specific target organizations, that model is significantly more efficient. Knowing people within the organization allows for building deeper trust compared to the previous lead-response approach focusing on new organizations.

We'll go to our next question from Steve Koenig with SMBC Nikko.

I have two financial questions. First, is there a mix shift toward cloud this year due to your forecast of 6% revenue growth alongside a 12% ACV growth?

That's a good question, Steve. The shift does not relate to a mix but rather to the substantial backlog from the end of '21 rolling into 2022, impacting revenue optics.

That makes sense. Now, regarding your fiscal '25 model, you mentioned that you'll update that at Investor Day in June. What is the thought process behind waiting, and can you give me directional insights on your long-term numbers?

We won't preview details of Investor Day, but we will provide commentary then. As for the Rule of 30 or 40, if we were in a normal growth environment in 2023, we might be able to achieve that. However, considering current conditions, it might take a bit more time, and we must see how free cash flow lands in 2023. Cash bookings have been built substantially over Q4, but some will carry into Q1 of '24, resulting in a somewhat back-loaded billing and collection period until our free cash flow model normalizes.

By midyear, in what ways might you have better visibility into the longer-term model or fiscal '24? What should we be looking for in early months?

One factor we'll observe after a few months into the year is how the economy shakes out. We’re in February now and have more insights than in November, but each passing month will provide additional clarity on whether 2024 could return to a more typical growth scenario or if it will remain challenging.

And we'll go next to Joe Mearus with Truist.

Nice quarter. We've heard a lot about vendor consolidation in the space. Have you seen proof of this? If not, do you think it's forthcoming and could provide upside to your 2023 guidance?

The clearest symptom of vendor consolidation is the hesitance to introduce new vendors. However, this isn’t favorable for those not already positioned well. We are witnessing an interest in consolidating different workflow systems into Pega’s core strengths, which serves us positively. That said, the number of vendors likely won't diminish drastically.

I believe clients are now thinking more critically about their vendor choices; rather than proliferating, they want to maintain the systems that effectively serve their needs. Many organizations are reevaluating their approaches.

As a follow-up, last quarter, you noted that $1 million purchases were higher than in the earlier quarters. Can you provide visibility into how they trended in Q4?

Q4 was a fairly typical quarter regarding the number of deals engaging over $1 million. While it wasn't a whale quarter, it was more dispersed across engagements with our clients, lacking reliance on any one or two significant deals.

With that, I want to apologize for the technical difficulties. We'll ensure that our Waltham office is thoroughly checked. We're always available for informal discussions. Remember PegaWorld from June 11 to 13. We anticipate a lot of exciting developments to share there. Thank you for participating in today's call and for your support as we work hard to drive a successful business. Have a great evening.

Thanks, everyone.

And so this concludes today's call. Thank you for your participation. You may now disconnect.