Pegasystems Inc Q1 FY2023 Earnings Call

Greetings and welcome to the Pegasystems First Quarter 2023 Earnings Results. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Kenneth Stillwell. Please proceed.

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q1 2023 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 2023 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 Q1 2023 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. We had a terrific start in 2023. Our team executed our strategy well, leveraging our strengths while remaining resilient in an environment that we expect will remain uncertain for some time. In Q1, we achieved ACV growth of 15% driven primarily by increasing our footprint in our existing clients, and through strength in Pega Cloud. This is exactly what we said we had tremendous opportunity, and where we should focus our sales and marketing efforts. We also saw select new logos, though that's not our focus for this year. Clients are responding positively to our architecture, our model, and our focus on deep engagement. Pega Cloud is driving growth, and cloud margins continue to scale. It's great to see us continuing to make solid progress towards becoming a Rule of 40 company, balancing growth with fiscal discipline and generating significant cash flow. Overall, our results reinforce the effectiveness of our strategy, and we see tremendous opportunity for growth. Ken will discuss our financial results in more detail in a moment. Now, I'm spending a lot of time with our clients, both at our Cambridge-based Executive Briefing Center, which continues to be solidly booked and on the road, including a trip to Europe I've just returned from. I continue to hear the same themes. Last week I was in Germany, Italy, and Sweden visiting clients, and despite the anxieties in Europe, the conversations I had were optimistic, and clients continue to be deeply interested in building relationships with Pega. Digital transformation remains a driving force as organizations look for solutions to better deliver personalized engagement and optimize business processes. A recent survey published noted that digital transformation was one of the top investment priorities for CIOs in 2023. Pega has a long history of helping clients improve efficiency and effectiveness as well as improve their customer experience. Clients are also very interested and in some ways concerned about the use of AI, especially with the newest generative technologies. They want to know how to leverage AI in responsible ways to drive automation without compromising enterprise governance or losing control of outcomes. Our approach to digital transformation and to AI is perfectly aligned to addressing these concerns and meeting these needs. Now to talk about our approach, our three-point strategy in developing software has always been about building technology that serves business people. We provide the most powerful and scalable low-code platform for AI-powered decision-making and workflow automation. We make it simpler for enterprises to work smarter, unify experiences, and adapt quickly. And we ensure that organizations can empower their employees without compromising enterprise IT integrity. We're combining AI and automation to enable organizations to become autonomous enterprises that self-optimize with business goals without sacrificing control. Now, as you've no doubt seen, there's an elevated interest in AI and lots of excitement and hype. And just as a reminder, since our founding four decades ago, Pega has helped enterprise clients use our AI-powered solutions to automate complex business processes, improve customer experience, and drive operational efficiency. We've been evolving our capabilities as the technology and our clients’ needs evolve. And we're in a unique position to lean on this heritage of harnessing, understanding and leveraging AI to provide unique capabilities to our clients. When we announced our generative AI plans last month, we stayed true to our approach with an offering that will allow clients to use the generative AI technology of their choice with enterprise governance to make generative AI truly enterprise-ready. We focus on building out use cases that maximize value and minimize risk. For example, we use generative AI to create better-performing marketing copy or to generate prototype applications from just a simple sentence. Our approach incorporates auditing and human approval, which are hallmarks of Pegas platform. This managed architectural foundation provides organizations with safety, security, and reliability, suitable for the enterprise. IT managers will be able to integrate their own specific generative AI APIs into Pega Infinity and centrally manage licenses and controls to give clients the flexibility to add existing or emerging generative AI APIs. A great example of our generative AI strategy coming to life is our recent inclusion in Amazon's announcement of Bedrock, a new AWS cloud service that allows developers to build and scale generative AI applications in the cloud. Because of our approach, we can easily integrate Bedrock into our platform and have use cases available to clients. At the same time, we can continue to support other cloud providers and other generative AI solutions based on our client's preferences. Now, we've been at the forefront of providing responsible AI for years and are committed to putting the controls straight into our software to ensure that fairness, transparency, and robustness all exist. We believe that rapid generative AI developments will make lower-end low-code providers a commodity. But on the other hand, the higher-end enterprise-grade solutions like Pega are going to benefit. So we're excited about the opportunity to create additional value by augmenting our solutions for organizations. Now, we have also rolled out Pega Cloud enhancements, supported by an enhanced global operations center that improves speed, scalability, agility, reliability, and security. These improvements help organizations maximize technology investments and deliver better experiences for staff and clients. And we'll continue to make progress with Pega Launchpad, which we announced last year as our new cloud-based low-code application development platform that empowers software providers to build and commercialize post-centric B2B apps. We're excited to be working with a select group of amazing early adopters; these Pega Launchpad powered apps are being built to address the needs of new markets that they will be pursuing. Now, we're coming up on PegaWorld Inspire our annual trade show and it's going to be fabulous. We'll be showcasing our new AI capabilities, announcing several new offerings, demonstrating solutions at more than 40 partner booths, and featuring over 200 demos in 100,000 square feet of pure ingenuity. We're also highlighting the success stories from more than 40 clients, including outstanding keynote presentations from Aflac. We will talk about how they are using Pega to reduce roadblocks and bottlenecks and manage staffing fluctuations and market pressures to continually deliver transformational outcomes. Citibank, one of our very first Pega clients, who went live originally on very different technology in 1984 is using Pega to deliver on its mission of being a trusted financial services partner, leveraging decision science to drive omni-channel customer-centric experiences. Rabobank from the Netherlands will demonstrate how they are revolutionizing customer experiences using our low-code and AI capabilities, and Virgin Media will describe their journey to become a fully digital business, leveraging Pega's customer service case management and AI-based decision-making. If you haven't yet, please check out the PegaWorld website, register, and join us to hear and see all of this in person, and especially feel free to join us for the investor session on Monday, June 12. To summarize, I'm pleased with our strong start in 2023 and our ongoing progress to be a Rule of 40 Case Company. Our results continue to be driven by ongoing demand from large global enterprises for digital transformation solutions that drive automation and leverage AI. Our strategy to focus our efforts on meaningful clients is proving effective and is making us feel really good about how we're doing in the market, as well as obviously winning business. We expect to face macroeconomic challenges in 2023, but I think we are well prepared and experienced with executing in challenging times. I feel confident that we are in the right space with the right capabilities and the right team, and our strategy is absolutely the right one to leverage the significant opportunity in front of us. To provide color on our financial results, let me now turn it over to our COO and CFO Kenneth Stillwell.

Thanks, Alan. Given an uncertain economic environment, it is great to see our team deliver such a strong start to 2023. The three most important metrics to measure the success of our business are annual contract value, ACV, cash flow, and backlog. So I'm going to focus my initial comments today on how we're progressing against these three critically important metrics. ACV grew 15% in constant currency year-over-year in Q1. Annual contract value growth has been and continues to be the most important metric for us. This strong result was powered by Pega Cloud ACV growth, which increased 24% in constant currency year-over-year. Pega Cloud represented approximately 67% of the $45 million of net new ACV added in the quarter in constant currency. Pega Cloud ACV continues to be the largest ACV component and the fastest growing. Our ACV growth was bolstered by our decision to realign our go-to-market strategy and focus our resources on deepening our relationships with our marquee customers. Our first-quarter results provided clear evidence this strategy is working. Our ACV growth was broad-based, and in addition, we are attracting new logos, although that is not our primary focus for 2023. Moving to cash flow. In Q1, we generated $68 million in operating cash flow which produced $75 million in our free cash flow metric, which is a great start to 2023. We still have a lot of work to do for the year, though. When we started our subscription transition in late 2017, our vision was to transform Pega's economic model and build a successful business for the long term while delivering tremendous value for our clients. Our strong ACV growth coupled with our strong free cash flow generation is the result of many years of hard work by our team to sharpen our growth strategy and efficiency. We're now running the business as a subscription business. We're really happy with the success we've had anchoring the concept of efficient growth. And as you can see from the results, we are starting to show progress through the first quarter numbers. We expanded Pega Cloud gross margin to 72% and we're increasing our operating leverage, and we believe there's more upside to our Pega Cloud gross margin in the future. Moving on to backlog, total backlog increased by 14% year-over-year in constant currency to $1.34 billion, driven by growth in Pega Cloud backlog. Revenue was impacted, as two-thirds of our net new ACV added came from Pega Cloud in Q1, and given that combined with a lower number of term license renewals, we would obviously recognize less revenue in the quarter than we did last year in the first quarter. That's because the majority of revenue from term license deals is recognized upfront upon renewal. In contrast, Pega Cloud revenues are recognized ratably over time. Given these dynamics, revenue and non-GAAP EPS in any individual quarter can be highly variable and sometimes it's not representative of the underlying fundamentals of what's happening in the business. For example, total revenue in Q1 was down 14% year-over-year driven by a 39% drop in term license revenue. We discussed this back in February. Our term license backlog was unusually high at $172 million in the fourth quarter of 2021, and you saw that backlog significantly impact revenue in the first quarter of 2022. Given that our term license backlog balance at the end of 2022 was significantly less than the prior year, we expected term license revenue in Q1 of '23 to decline significantly year-over-year. We also repurchased $33 million of our $600 million convertible notes at approximately a 10% discount. This transaction was not part of a formal repurchase policy; rather, as we generate cash, we will look to opportunistically retire our convertible debt. Similarly, to last quarter, given an uncertain economic environment, we thought it would be helpful to provide some thoughts on modeling our business. Our practice is to provide annual guidance at the start of the year, and not to update guidance unless we've made a material acquisition or something else materially happens in the business like we mentioned last year; we do not provide quarterly guidance. Given our focus on increasing cash flow, we added a new metric this year: free cash flow. Our commitment to generating free cash flow is strong. As a company, we understand the value, especially in an uncertain growth environment, of delivering both consistent free cash flow generation and free cash flow improvement as we scale. That way, when we actually see these periods that are less certain in the growth environment when the economic climate is not as welcoming we establish a solid free cash flow based business. And as we expect our sales and marketing expenses to be higher in the first half of 2023 compared to the second half, that's driven by our PegaWorld Conference being live in 2023 for the first time since 2019. I'm very excited that our investor session will once again be held in person in Las Vegas after four years of virtual sessions. On Monday, June 12, at PegaWorld, we will host investors to discuss our long-term model and our long-term strategy. If you're interested in registering for the investor session, please email pegainvestorrelations@pega.com. The agenda will include updates on our go-to-market strategy, our product innovation, and also our financial model. We will also include time on the agenda, as usual, for questions and discussion. In closing, our team executed very well in the first quarter of 2023. Of course, we're still facing an uncertain economic environment along with all of our other participants in the software market. So we're going to continue focusing on those three most important metrics as I mentioned: ACV, cash flow, and backlog.

Thank you. We will now begin the question and answer session. Your first question comes from Kevin Kumar with Goldman Sachs. Please go ahead.

Thanks for taking my question. Kenneth, the guidance provided last quarter for 2023 I believe factored in some softness in the macro environment. Have you seen anything materialize in terms of lengthening of deal sales cycles or changes to close rates? Or have those held up relatively well?

Yes, great question, Kevin. So there are a couple of aspects to that. The first one is, in terms of our team executing against our sales campaigns in our pipeline, I wouldn't say there was any deterioration that we saw in Q1. I think we executed well. I think our clients are still engaging and are very committed to their digital transformation initiatives. That said, you can definitely sense that there's some level of economic concern out there, as there was last year, but I think our execution against our pipeline was solid. So I think there's two pieces of that. The execution was good, but you can feel the uncertainty or the kind of timidity that's out there in the marketplace. But we haven't seen that translate into actual statistical deterioration of our close metrics.

Yes, that's helpful. And then curious on the comment on logo adds. I know the focus has been more on expansion within existing customers, and there's been some changes in the sales organization to focus on that. So what was that kind of the natural course of the sales process? And just curious those remaining for contributors.

Well, it's Alan. We do get inbound customers, meaningful organizations, that either have somebody who's worked with us somewhere else or see what leading companies are doing in various industries. And those are the basis of how we are and will in the future, be adding new logos because that's very consistent with our strategy. I will tell you that by giving ourselves the capacity to spend a lot more time with several hundred customers that are critical to us and we have significant relationships with, we have absolutely uncovered the opportunity types that we had expected working with those companies and see both the upside, and candidly are really building and continuing to improve great relationships with very important organizations. So the strategy feels really good particularly in a year that's maybe a little tougher.

I would also add one other point to that which is, I wanted to be very clear, because I think that there are some people that heard the message of our strategy that we were not entertaining new logos or that somehow new clients were not important to Pega; that is not true. It's just not where the majority of our focus is because we think the opportunity is with our existing clients. But as Alan said, there are lots of companies out there that look just like our clients that are not current clients of Pega. And sometimes we find them and sometimes they find us, and I think that will continue to happen. I just wanted to make sure that nuance was clear.

Great. Thank you both.

Thank you.

Hi, this is Richard Poland on Rishi. Thanks for taking my question. So I guess the first one is a two-part question around generative AI and kind of what you're doing in that lane. So it sounds like a lot of the value proposition is the security and compliance that you're wrapping around some of the AI technologies, and it's a really exciting opportunity. But can you elaborate a little bit on how you're differentiating against the other generative AI type solutions out there? And then just a follow-up on that is just how you think about the monetization opportunity long term? Thanks.

Sure. So I think we've got a structural advantage compared to lots of other companies because Pega has always been a model-driven company. What that means is you create a model of how you want your business to run, and from that model, our system actually writes the software. We're using the generative technology to basically inform the model. So for instance, you can say, hey, I want to define a process for home equity loans, and generative AI will do a terrific job of identifying one of the stages you would go through, what a data schema would look like that would capture the information that you would need, and what sample data might look like for testing. All of those are components that go into our model. It gives you such an amazing opportunity to really jumpstart, but also simplify a lot of things about how you apply technology to your business. So those are the types of examples; things that really leverage an architecture that I think is extremely well suited, and candidly, a lot of the companies that have been talking about low-code are in enormous trouble because low-code apps that don't fit a real enterprise standard, and don't have the right structures, I think in many cases are just going to be replaced by people using generative AI to write the code. But there's a huge market for things that are a little more sophisticated, need to be updated routinely. So you don't just do it once and use it, but you want to be updated again six months later. And those are the types of things that I think we have a structural advantage towards what we are doing. Monetizing it, I think this is absolutely going to drive additional demand for Pega and a variety of use cases. And with our clients in general, when they use our software more, it gives us a chance to get paid more, which is good for them and for us. So I think that this has, candidly, a lot of appropriate excitement in addition to the hype, we see, which is nonstop, but we're not affected by that. It's just part of, I think, having a pretty mature understanding of what AI is about. And we were on this technology long before it broke into mainstream media.

Thank you, Alan. That's super insightful. And then maybe one for Ken. Just as we think about the pace of Pega Cloud gross margin expansion, and it's been really solid in the past recent years. How should we think about that kind of going forward? I know one of the previous targets, I think, was in the mid to high 70s range by 2025. Is that still the track we should think about for Pega Cloud gross margins? Thanks.

Sure. So maybe it's interesting to paint the picture. When we first started Pega Cloud, the first couple of years, our gross margin was 35%, then it was 45%. Then it was 50%. And then when it was about 50%, we set a target of 70%. And now that we've surpassed that, we moved the target to 75% a couple of years ago, and then we said we could potentially reach the high 70s. Naturally, that can't go on forever, of course, right? Because at some point, you do hit a point where the efficiency has to stabilize. But I think like best-in-class SaaS companies would strive to have gross margins that begin with an eight, right? And so we want to be best in class, and we're starting to get some good scale. So I think 75% to high 70s is maybe a mile marker on that journey to being a best-in-class SaaS company from a gross margin standpoint.

I would just throw in that the way this has been achieved has been through the excellent collaborative work of the team both in terms of putting extensive automation into our cloud operations that both save money but also make the system more reliable and more effective for our clients. Being able to rework the system to be cloud-oriented and a microservices-oriented architecture has made a significant difference. There are a lot of improvements that go beyond just the financial aspects that we can still achieve. So while we can't raise the bar forever, I believe we have a little more room for improvement.

Thank you. Very helpful, guys.

All right, great. Thanks for taking the question here. I guess maybe just following up on the AI discussion. How do you think about where you have a right to win and will be focusing on your AI initiatives and embedding that in the product versus maybe looking at the rest of the technology ecosystem and partnering with other technology vendors or third parties to embed some of that functionality into your product set?

Well, we're definitely building our generative capabilities to be able to partner. We talked about the partnership with AWS. Partnership with other major AI providers also is central to how we're going to go to market. So we see being able to use the super rapidly emerging large language model capabilities that will continue to evolve as something that needs to be part of our open architecture. Of course, we also have some of our AI capabilities, like our customer decision hub and process AI, which is the ability to use AI in processes to make them learning and self-optimizing. I feel well-equipped to be a significant player, in types of customers we know we can serve, who have enterprise needs that fit perfectly with what we're considering and doing. We're getting great feedback from the early clients and showing us that we're absolutely on the right track.

Okay, understood, and appreciate the thoughts there. I guess for Ken, really good cash flow in the quarter, and that really contributed half of the initial guidance you provided for the year. Was there anything one-time in nature that might not pull into the quarter, or anything we should be thinking about as we think about free cash flow throughout the rest of the year?

Yes, sure. Steve, just a reminder that typically, our billings are higher in Q4 and Q1, which would mean that our collections would be higher in those quarters. Now, that said, we do have a lot of cash outlays in Q1. For example, we have our annual commission payments that go out. So we have a higher payment of a commission quarter typically because Q4 tends to be higher in bookings. So there were some offsets to that, but I would say Q1 was very strong in terms of free cash flow.

Okay, appreciate the great answer there. Thanks again for taking the questions.

Sure.

Hey, thanks for taking my questions. Alan, just wanted to dig deeper into your comment that generative AI could commoditize lower-end low-code use cases. Could you just talk a little bit more about what Pega's history in the AI world and its positioning, and how more mission-critical workflows help you really take advantage of the opportunities from the AI team moving forward?

Well, sure, and I also can explain why I think our positioning and our technology provide a moat that's consistent with our enterprise approach. When Pega goes into a customer, we talk about building a low-code app factory. That means we’re able to build apps quickly, but it also means they have a structure that lets them be hooked together, which allows them to leverage other enterprise assets, like the interfaces and controls that are going to be consistent or related across apps. This ability to have what we call a layer cake, where certain things go across the entire customer enterprise and other things might vary with different divisions of a bank or an insurance company, really distinguishes us from companies that have a bunch of isolated apps running around. Companies betting their future on generating low-code apps that do simple things, or that run on a mobile device, are going to find the market will shake out, because it will be difficult to continue to maintain those without enterprise structure.

Very helpful. Thanks for that color. Ken, how do you feel about the pace of your subscription transition at the start of this year? Have you seen any impact of the migration as a result of the macro? And do you feel like Pega is still on track to complete the transition this year and be a cornerstone for the business as you exit 2024?

So the subscription transition pace, I think is I'm very happy with it. There has been some maybe it took a little longer to get through the financial transformation from subscription than what I had originally envisioned, but in general, it's going well. Not every client is going to want Pega Cloud; that's an important note. We want every client to have Pega Cloud, but the reality is some clients may choose to manage it themselves or may not have the use case to move. That said, a significant number of our clients will move to Pega Cloud, and many are doing so regularly. As for clients viewing moving to a vendor cloud like Pega Cloud to solve some financial inefficiencies, I think it really depends on the individual client's perspective. Overall, in a tougher environment, there may be more inclination to move to Pega Cloud, but that's not a universal truth.

Yes. It's also beneficial that customers are under pressure in terms of retaining skilled staff. It's much easier for them when we're operating and running it. But to make it tangible, we have some large customers where we have systems that literally handle tens of millions of cases a month, woven into their processes, combining automation and leveraging the cloud.

Hey, thanks for taking the question. Ken, I'll try one more time on the SCF performance seems pretty strong. It seems like the change in working capital was positive after a long time in Q1. And then it seems like the SBC jumped a little bit. I want to just make sure there's not a one-time thing that's driving this just thinking through what should we expect for the year on free cash flow.

Sorry, Pinjalim, I heard the free cash flow point, but did you say SBC for the second point?

The stock-based compensation seems to have jumped a little bit.

Yes. I'll explain. There's a higher stock-based compensation in the beginning of 2023 due to two factors primarily: one, we adjusted our vesting period from five to four years, which will drive a near-term acceleration, but it won't be a lasting change. The second factor is that we made an equity grant that was out of cycle in the second half of 2022, which is in the calculation for 2023 but will not repeat. So there's some one-time pressure there that is not a structural change to our stock-based compensation strategy.

Yes. Understood. Very clear. One for Alan. Obviously, we have heard a lot of AI in this call and you're doing a lot of things around AI. I want to ask you about how you think about the potential to capture incremental value from the efficiency that customers will gain from using AI capabilities, versus the potential pressure on seats that those efficiencies might actually drive.

So I think for a lot of folks, the automation that occurs is going to put potential pressure on seats because, if you can automate tasks through self-service or better chatbots, that will obviously reduce the number of contact center seats needed. However, to the extent that we are providing the tooling to manage client interactions, including the automated ones, we've really moved away from user-based pricing on a few seats. It's better for the customer and eases the pressure. Maintaining an effective balance to drive automation will remain vital.

Hi, Gentlemen, thanks for taking my questions. Congratulations on a great start to the year. Just maybe a housekeeping question or two for Ken, and then a question for Alan. Ken, you mentioned that 67% of net new ACV is cloud. Just so I'm clear, are you guys basing that assumption on cloud percentage of new client commitments? Is that the same definition that you're using for this net new ACV?

Yes, Steve, we did. We're trying to be very consistent with that metric to what our reported metric is because it can sometimes get confusing when we use a metric that may span one or two quarters versus a single quarter. So yes, it’s essentially the same measure. We just felt like it would be much easier to discuss this metric, as it will translate into revenue, billings, and backlog.

Got it. That makes sense, we can calculate that from the financials. So that's great. Okay, so you're on track with your guide so far in terms of your cloud assumption, is my takeaway there. And then we also noticed that the cloud ACV and RPO was very good and a quarter better than we expected. Can you speak to whether there were some back-end loaded cloud deals that should help cloud revenue next quarter?

Revenue lags ACV for sure. When we booked deals, they typically don't have a revenue impact in the quarter. I'm generalizing, but there's definitely a lagging effect there. Yes, we think that for our term license revenue for 2023, that would be more back loaded, because that's when the renewals are happening.

Got it. Great, thanks, super. So moving yet another question on generative AI, but very relevant here. I think Alan, one of the criticisms of Pega over the years is that there aren't as many Pega developers as there are Java developers, making it hard to scale. But you’ve grown your ecosystem, very well, and focused on that very nicely. Does this generative AI capability make the current Pega trained developers more productive, or can it democratize the development of a model?

The advent of generative AI takes a massive change to both of those points. It will make existing developers much more productive but opens up the technology to a broader group of citizen developers. We can leverage our structure, because a lot of citizen developer tools have risks of not offering the right guidance for enterprises. We can still provide that guidance and control while making it so that the logic does not require deep Pega knowledge but can be interpreted from natural language. This structure enables us to not just create a small app, but to create robust, interconnected systems.

Got it. Hey, thanks a lot. Congrats again.

Thank you.

This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.