Pegasystems Inc Q2 FY2023 Earnings Call

Greetings and welcome to the Pegasystems Second Quarter 2023 Earnings Conference Call. This conference is being recorded. It is now my pleasure to introduce your host, Peter Welburn, Vice President of Corporate Development and Investor Relations. Thank you, sir. You may begin.

Good morning, everyone, and welcome to Pegasystems' Q2 2023 Earnings Call. Before we begin, I would like to read our safe harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, forecasts and guidance; 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 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 forward-looking statements are contained in the company's press release announcing its Q2 2023 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 in 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 views 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, Peter; and to everyone who has joined today's call, especially those of you who've gotten up quite early to do so. I wanted to reinforce that at PegaWorld last month I had the opportunity to spend time with many of our clients and have very meaningful conversations. In those discussions and through virtual discussions, it was clear our clients want to talk about the future of AI; specifically about the impact of generative AI and how they should be thinking about it, how we are approaching it, and how they can leverage AI responsibly and safely. Clients see that this technology will change their business in fundamental ways and are excited about the potential. At the same time, there is much information in the market and many opinions. They are eager to learn more and separate the marketing hype from reality. It's clear this technology is going to drive massive shifts in how we get work done; and in Pega's world, how applications are designed, built, evolve, and are supported. We believe Pega is uniquely positioned to leverage this technology, bringing it to our clients in a safe and secure way and taking advantage of this massive opportunity. Now for those who attended PegaWorld, you saw this firsthand on the main stage as well as during our investor sessions. We believe that generative AI will accelerate the adoption of Pega, making it easier, faster, and cheaper to deploy, improving the client experience and driving expansion of existing relationships. That will translate into helping our clients leverage generative AI in their organizations to improve efficiency, save money, and enhance employee and customer satisfaction. Nonetheless, there are concerns about the overall economic environment, and clients are being conservative in their decision-making, even as they engage in these very positive conversations more deeply. Taking client feedback in and evaluating the impact of this new technology, we've realized we have further opportunities to streamline how we engage with our clients. During this quarter, we will be working with our teams on ways to get even closer to our customers. Because AI is so important, I want to take a minute to reiterate why Pega is uniquely positioned to leverage generative AI and why this will bring special benefits to our clients. Pega has been integrating and innovating the use of artificial intelligence and automation since I founded the company, and we've gone through many evolutions. I think this is as exciting an evolution as I've ever seen. I believe we understand what clients need, and we can drive value and acceleration from generative AI while preserving the scale and scope that enterprises demand. A big piece of this that is unique to Pega is we've built an architecture that is perfectly suited to tap into the disruptive power of generative AI both today and well into the future, and we know how to monetize it. Most companies are thinking about generative AI as a code generator of one form or another, but that will really only get them so far. Going directly from prompts to code doesn't provide the structured enterprise needs to create an evolving enterprise-class system. In contrast, Pega has always been based on the concept of a business model at the center that creates a structure and system able to adapt as industry and customer needs change. Our architecture is built on what we call the situational layer cake. You're going to hear me talk about the layer cake a lot, not just now, but in coming quarters, as it helps to really power this revolution. It's a proprietary capability that organizes all of an enterprise's processes, rules, data models, and UI into layers, so it supports building and reusing. This layer cake is the perfect place to plug-in generative AI. It creates a space that, after the generative AI contributes, people can see the model, understand it, and regenerate it as needed. It is this layer cake, this architecture, that is what Pega is uniquely able to provide our clients, a proprietary structural advantage at the heart of our products. It's not something that can be easily copied or reproduced, and it allows us to develop integrated generative AI rapidly and seamlessly. We've been at the forefront of using AI in responsible ways, and the company's responsible AI frameworks are trusted by our clients. These will be critical as they build their own AI models. The layer cake helps us by creating visibility for what comes from Pega versus what a customer might build or develop independently on top of it. This combination of architecture, experience, and capabilities, I believe, will make us more successful than our competitors because it will help our clients be more successful, allowing them to adapt and build for change. By the way, I think generative AI is going to be devastating to most of the low-code companies that haven't taken this approach. As a result, you already see some players starting to talk less about using low code. While in Pega we're still discussing low code because we've always used it in a way that provides the necessary structure, almost presciently designed for the introduction of concepts like generative AI. I expect that we will monetize generative AI in three ways. First, clients will create more Pega apps and process more work on our platform. Most of our licenses are already work quantity-based. Years ago, we began moving away from seat licenses because seats are going to decrease, or if the industry does the right thing, they should go down a lot. We saw this coming long ago. You can think of most of our licenses as being consumption- and capacity-based, which I believe is the type of licensing you want in this sort of environment; it's good for the client and good for us. Secondly, I do believe we will see that, as we're in this generative AI work in Pega Cloud, leading with Pega Cloud will serve as a catalyst for more clients to move from existing term or maintenance contracts to Pega Cloud subscription agreements. Third, we will offer specific generative AI-powered add-on features, which will incur an additional charge. We recently announced 20 generative AI boosters to be available with Pega Infinity 2023 this summer, and we've just gotten started. In fact, our engineering team began this year with a generative AI-focused hackathon that resulted in over 100 new prototypes and capabilities, many of which made it to Infinity 2023, with much more to come in subsequent releases. We have clients who are signing up to be early adopters already, and they are engaged and excited about these capabilities. We're enthusiastic about working with them and seeing what we can accomplish together. Before I move on, I want to provide additional color on PegaWorld because it was spectacular. This was the first time we came together in person since 2019, and the energy and excitement was palpable. If you couldn't join, or would just like to see all of the replays, they're available on pega.com. We had over 3,500 attendees from around the world, representing over 47 countries. We had inspiring keynotes from clients like Virgin Media, Rabobank, Citi, and Aflac, who shared how they are using Pega to drive their business. We also had more than 80 deep-dive breakout sessions with additional clients sharing stories from companies including BT, Google, Santander, Siemens, T-Mobile, UnitedHealthcare, Verizon, and Wells Fargo. One breakout was presented by LeasePlan, who discussed their transition to a fully digital business model, leveraging Pega in their center of excellence towards their vision of becoming a car-as-a-service organization with a strong focus on service efficiency and digital channels. Clients value being able to connect with peers and learn from Pega journeys. They expressed that, in person, they could accomplish in just a few days what might have taken weeks or months in terms of discovery, getting questions answered, experiencing technology, and ultimately understanding the value Pega provides. Positive feedback was received about our client-first target board model, providing a more focused and dedicated engagement team to stay close to our clients. They're excited about the new capabilities and look forward to our continued approach to generative AI, seeking ways to accelerate development and improve the function of business users without needing traditional, longer approaches. I came away feeling energized and convinced we have the right client engagement style, technology, and team to drive success for our clients and Pega. As we move into the second half of the year, we will look to double down and push on our strategy to improve operating effectiveness with further improvements to our go-to-market alignment, maintaining and increasing focus here. In summary, we are committed to building a successful company for the long term; helping our clients navigate what is, candidly, a challenging selling environment that we believe may persist. Let's face it, the world is uncertain and rapidly changing. However, I believe we have the right strategy to succeed in this environment while building for the future. Our focus is on our client base with solutions that drive efficiency and cost savings, helping them navigate the macroeconomic conditions. We see that generative AI will rapidly change the landscape of how work gets done and we have a unique, sustainable advantage that we can leverage. We're making good progress toward being a Rule of 40 company as we exit next year, balancing growth with fiscal discipline and generating significant cash flow.

Thanks, Alan. Our first half results demonstrate our ability to generate increasing amounts of free cash flow while maintaining a double-digit growth rate. The growth in annual contract value or ACV continues to be the most crucial metric to assess our business success. At the midpoint of 2023, ACV grew 13% year-over-year. This growth was driven by the continued momentum of Pega Cloud ACV, which reached $499 million at the end of the second quarter. I'm excited that our Pega Cloud SaaS business continues to be the largest and fastest-growing ACV component, with backlog growing by 23% or $164 million year-over-year. Pega Cloud now represents more than two-thirds of total backlog. This growth underscores the underlying strength and momentum of our subscription transition. Another key metric for measuring business success is cash flow. In the first half of 2023, Pega generated $114 million of cash flow from operations and $123 million of free cash flow—an excellent accomplishment. $123 million is the highest amount of free cash flow generated in the first half of a year in the company's history. Several factors contributed to this result. In late 2017, we commenced the subscription transition from selling perpetual software licenses to primarily subscription offerings. We embraced this model due to client demand for a fully managed offering as a modern way to access our technology. We also preferred that recurring billings and cash collections are more durable and predictable. We knew cash flow would improve as we exited the subscription transition, and seeing Pega generate record free cash flow in the first half is a great step forward in realizing that vision. As part of our transition, we emphasized driving free cash flow through being more disciplined in hiring and more selective with third-party spending. I am noticing numerous examples where our team members are making meaningful steps to improve profitability. We're also better aligning our spending with our ACV growth drivers. Over 90% of our ACV growth this year is expected to originate from existing clients, thanks to our high client retention rates and cross-sell and upsell activity. Selling into existing clients is far more efficient than acquiring new logos, especially in times of economic uncertainty. A reminder: in our subscription-based business, significant term license revenue generates a mismatch between billings and revenue. Under ASC 606, the majority of term license software revenue is recognized upfront. However, billings and cash collections primarily occur one year in advance in equal installments across the contract. This dynamic allows us to generate strong cash flow even as reported revenue fluctuates. Collectively, our mid-year results demonstrate our progress on managing the company with a focus on the Rule of 40. We define the Rule of 40 as the combination of ACV growth and free cash flow margin. Hitting this milestone is vital for us at Pega, and it provides us another reason to be proud of our business. Generating solid free cash flow fuels investments in our company and supports outstanding client service. It also gives us the financial strength and flexibility to navigate uncertain economic environments. For instance, in the first half of 2023, our cash and marketable security balance grew, allowing us to repurchase about $90 million of our convertible debt at a discount. At the end of Q2, our outstanding convertible debt balance was approximately $500 million. As outlined in our investor session at PegaWorld in June, we see three major levers for achieving the free cash flow margin necessary to meet the Rule of 40. The first lever is expanding total gross margin, driven by Pega Cloud gross margin, term maintenance gross margin, and our professional services gross margin. Improving Pega Cloud gross margin will be the most significant driver of total gross margin improvement. We're working to enhance Pega Cloud gross margin by scaling Pega Cloud, increasing automation, and implementing multi-tenancy in Kubernetes. Pega Cloud revenue has grown to $423 million, up from about $50 million a few years back. In the first half of 2023, Pega Cloud gross margin improved from 68% to 73% year-over-year. The second major lever for operating leverage is sales and marketing, which is the most challenging component. We're balancing the need for investment in sales and marketing to drive ACV growth with enhancing sales efficiency. We're evaluating feedback from clients, partners, and employees on ways to further simplify client engagement to drive greater success. We plan to implement changes in the second half of the year for continued improvement in go-to-market productivity. The third lever for improving operating leverage is in research and development and G&A. We plan to increase R&D and G&A spending at a slower rate than we expect the company to grow. Delivering top-notch innovation to our clients is critical, and we plan to keep investing heavily in R&D while improving efficiency. We're concentrating on growth, gross margin expansion, improving sales efficiency, and increasing operating leverage. Companies that do well in uncertain economic times focus on growth, expense management, and generating free cash flow. It's reassuring for our clients that Pega maintains the financial strength to continue delivering outstanding customer support and product innovation. I have been asked to offer a brief perspective on modeling our business in the second half of 2023. Typically, Q3 is one of the lightest quarters for term license revenue due to seasonality. We often book far fewer renewals of term license agreements during this period, while Q4 is relatively stronger as we experience higher contract renewals. In conclusion, it was great seeing many of you in person during our investor session in June at PegaWorld in Las Vegas. I'm looking forward to getting back on the road in August and September.

Thank you. We will now have a question-and-answer session. Our first question comes from Steve Enders with Citi. Please go ahead with your question.

Okay, great. Thanks for taking the question this morning. I guess, I just want to ask first on what you are seeing out there in the macro situation and some of the uncertainty with customer budgets and how that relates to the sequential decline we saw here on the ACV line in the quarter.

Hi, Steve, it's Ken. Let me address the second part of your question before passing it to Alan for his insights on the market landscape. It's not typical to see a sequential decline in ACV within a quarter, but it can happen, particularly after a strong increase in the first quarter. Various anomalies can affect a quarter, especially regarding renewals and client churn. We prefer a trailing 12-month perspective rather than focusing on short periods. While it is unusual to experience this decline, we don't see it as a systemic issue and believe it won't hinder our ability to achieve our full-year results.

Yes. The market is definitely being conservative. We're seeing more approvals popping in at the last moment, with some things that you would have expected to close fairly quickly. Some of those have since closed, but they just took longer. There is an extra level of scrutiny happening within our client companies, which I've seen before in uncertain times. I expect this will be the case for a lot of other companies and potentially for the next quarter or two. However, I don't think this will affect our long-term prospects in any way.

Okay, no, that's helpful context there, and I appreciate the comments around that. I guess, given the budget situation we're discussing and the excitement around AI, how are you thinking about the path to monetization for all the new functionality talked about and released at PegaWorld last month? How are customers feeling about their investments in PEG AI going forward?

Look. Customers are bombarded with every company trying to offer them AI miracles. The hype cycle here is unprecedented, to tell you the truth. However, we have a lot of credibility with our clients, particularly when we show them the real things we demonstrated at PegaWorld. There is tremendous interest and confidence from our clients that our way of implementing AI will work. Many customers are conducting their own experiments and dipping their toes into many areas, including analytics. There's so much activity and interest, and we are doing well. I’ve been in many meetings discussing why the Pega approach is differentiated and architecturally superior, and I expect this will lead to greater usage, which we are ready for.

Okay, perfect. Thanks for taking the questions.

Our next question comes from Kevin Kumar with Goldman Sachs. Please proceed with your question.

Thanks for taking my question. I had one on cash flow, which was very strong in the first half of the year. Ken, I know you updated guidance during Investor Day to $180 million for the year. It feels like you're tracking ahead of that, especially since Q4 tends to be a strong quarter. Is that still the right way to think about this? Anything else you would call out regarding the cadence of cash flow for the year?

Hey, Kevin, thanks for your question. It would be foolish for me to suggest that being where we are at the midpoint isn’t a good sign for achieving our cash flow for the year. I don’t think $150 million or $180 million are endpoints. We’ll aim to generate as much cash flow as possible because higher cash flow this year means our structure is set to grow cash flow in future years. So, we’re not updating guidance, but we’re pleased with our position and believe it bodes well for future cash flow increases.

I'll add that the company’s mood has significantly changed, moving toward a culture of balance aiming for Rule of 30 this year and Rule of 40 next year. This transformation didn't happen by chance; it’s due to personnel focusing on being more economical while pursuing our Rule targets.

That's great. Thanks for the context there. I had one regarding Europe. The segment revenue details imply Europe accelerated revenue growth in the first half. Is that catch-up, or is there any recovery you see in different regions? Any insights from your customer base?

Please be careful how much you consider segment reporting by region, as a lot of our revenue still comes from term licenses under ASC 606. Timing can cause differences in how revenue flows geographically. That said, we’ve not seen noticeable positive or negative changes in our theaters in the first half, so I believe the varied revenue flow is more attributed to timing than to actual economic changes.

Understood. Thanks for taking my questions.

Yes.

Our next question comes from Rishi Jaluria with RBC Capital Markets. Please proceed with your question.

Wonderful. Thanks for taking my questions. First, I wanted to touch on the consumption element of the business. At the Analyst Day, you said that part of the goal of generative AI is driving more consumption. Can you remind us about how much of the business is actually consumption? And as we look at adopting generative AI solutions, what does that do to the mix of consumption versus subscription? How will that affect key metrics like ACV and RPO?

Let me start, and then Alan can add. When we speak of consumption, we refer to contracts that have a usage or consumption metric; an increase in this metric allows value sharing between our clients and us. Over 50% of our contracts utilize a consumption metric. That said, the amount of ACV driven by variances in contractually committed arrangements with clients is still relatively small. Usually, when clients exceed their contract, we re-contract. Most of our agreements are designed to avoid significant fluctuations in costs quarter to quarter, thus enabling better budgeting.

To clarify, when we began moving to a non-seat model, we converged subscription and consumption. Clients prefer that their costs do not fluctuate too much, which helps with predictability in budgeting. Instead of overage charges, we adjust subscription prices based on increased use, making it simpler for clients to forecast their expenses.

Great, that's a thorough answer. I appreciate it. Then...

I want to clarify—when moving to a usage-based model, contracts could have slightly shorter durations, potentially slowing RPO growth. This impacts ACV minimally but is one part of the question you raised, as we wish to boost our clients' usage to grow ACV. Longer contract durations lock in usage for extended periods.

Okay, really helpful. Thanks. Additionally, during discussions with partners at PegaWorld, it was mentioned that generative AI can help speed up time to value. Based on your conversations with customers, what is the potential for generative AI to reduce implementation times, sales cycles, and perhaps lead to better net new business?

I expect significant changes. In my closing remarks at PegaWorld, I outlined four aspects that the company is focusing on. The first involves using generative AI to provide advice to both software builders and end-users. We aim to double developer productivity directly from these features. This will undoubtedly accelerate sales cycles and enable clients to accomplish more with existing budgets. We're also working hard to excite our partners about the resulting efficiencies.

Got it. Perfect. Thank you.

Our next question comes from Pinjalim Bora with JPMorgan. Please proceed with your question.

Great. Hey, guys, thanks for taking the question. I wanted to ask about the opportunity you discussed in the script about streamlining sales and improving go-to-market operations. Can you provide more insights on that?

Yes. We've just started sharing those insights company-wide. I'll spend time today discussing our plans, but in principle, we're integrating several roles traditionally viewed as separate—like success managers and account executives—under a unified organizational structure. This will improve effectiveness and aligns with the feedback from clients who prefer to engage with focused teams. I believe this will enhance sales efficiency but is not the primary driver.

Understood. And Ken, regarding the sequential decline in ACV: Was the macro situation worse in Q2 compared to Q1? Is there anything to note?

I don't believe the macro was worse. Q1 performance exceeded Q2, which naturally contributes to the decline. This variability occurs in businesses like ours with fewer deals. Since our deals have larger values, they do not consistently reflect statistical trends.

Understood. Thank you.

Our next question comes from Jake Roberge with William Blair. Please proceed with your question.

Hey, guys. Thanks for taking my question. I want to delve deeper into your comments about generative AI commoditizing low-end use cases in low code. Can you explain why your platform's positioning allows you to leverage AI, and regarding timing, when can we expect to see AI integrated into the model? Will this generate revenue more in Q4 or is it primarily a 2024 story?

Several aspects to address here. Many are building AI systems to speed traditional coding, such as using copilots that tie systems together. However, generating systems this way typically lacks adaptability. The Pega layer cake allows organizing key change dimensions for businesses, which supports structured modifications. We anticipate delivering the AI features this year, making them available to customers when '23 launches this summer.

Helpful context. Regarding platform consolidation and the uncertain macro environment, have you seen changes in competition or the response from your GSI partnerships as larger software platforms invest in this space?

We see tangible benefits in the pipeline and in real implementations as clients use us to enhance workflows. This consolidation presents a substantial opportunity compared to other product families, like process mining and robotic automation. I'm confident that such a trend will benefit us.

Helpful. Thanks for your questions.

Our next question comes from Vinod Srinivasaraghavan from Barclays. Please proceed with your question.

Hi, guys. Thanks for taking my question. I wanted to follow up on some macro and generative AI queries. It appears there's a balance between generative AI's growing influence and macro factors creating headwinds. When do you expect generative AI to dominate, resulting in a strengthened pipeline and net new ACV growth?

I think the dominance of generative AI will be reflected in tangible applications in client hands. A lot of AI products are out there, but once they're fully operational and shown to provide real value, the dynamics will shift. Macro conservatism is creating additional scrutiny, leading to approvals that can slow processes. We need a strong acceleration in adoption to increase our Rule of 40 aspirations next year.

Understood. Thank you. On the Rule of 40 and scaling Pega Cloud, can you clarify how you envision modeling Pega Cloud gross margin as you reach milestones like externalized services for microservices by Infinity '24?

We previously aimed to elevate the Pega Cloud gross margin to 70%, then up to 75%, and we're now near 75%. We foresee it potentially approaching 80% in coming years. Modeling this gross margin would be more linear as we scale. That's one aspect of our business that has consistent linearity.

We implement improvements every quarter.

Thank you. I appreciate it.

Our next question comes from Fred Havemeyer with Macquarie. Please proceed with your question.

Thank you very much. Good to speak to Alan and Ken. I initially had technical questions, but something piqued my interest. How do you see the opportunity to improve customer service and sales efficiency with generative AI in enterprise environments?

I think the opportunity is enormous, both in assisted and fundamentally changed self-service. We want to benefit clients seeking labor-saving strategies, especially in a market where finding labor can be challenging. We have a collection of elements primed for this change.

Looking forward to it. One last question on your partners. How are they approaching their strategies around no code, low code, and generative AI for their clients? Is there any headwind on platform adoption?

There's extensive experimentation in the business environment as clients assess what’s real versus the hype. Our partner engagements have been highly enthusiastic, though their excitement may not extend to all other vendors.

Our next question comes from Mark Schappel with Loop Capital Markets. Please proceed.

Thanks for taking my question. Alan, regarding Launchpad, you discussed its capabilities at the recent Investor Day. Can you update us on the early adopter program and the aspects partners find most exciting?

The early adopter program is oversubscribed, and partners are enthusiastic about what we're doing. Launchpad allows partners to capture their IP and offer services powered by Pega, a unique position in the market. While reluctant to project numbers this year given its nascent nature, I expect to share Launchpad's contributions to our financial strength in the following year.

Our next question comes from Tom Blakey with KeyBanc Capital Markets. Please proceed with your question.

Hey, Alan and Ken. Thanks for squeezing me in. I'm trying to balance these moving macro parts, as it seems to be incrementally concerning, while AI appears bullish. Given the $1.4 billion calendar '23 guide, do you see AI becoming an incremental factor? Please help me understand the status of our guidance when adjusted for macro influences.

The Pega Cloud momentum creates variability in reported revenue. While grounding discussions about ACV and billings is essential, revenue can shift because of the contract timing associated with Pega Cloud.

Regarding macro factors, while economic uncertainty leads to more scrutiny, generative AI represents significant long-term potential. We need to navigate mixed results while striving for consistency.

Regarding cash flow, your convertible debt is trading at an 8% or 9% discount. Could you provide an update on your capital structure and how it might impact the Rule of 40?

We are not aggressively buying back converts, though we view situations opportunistically. Our actions highlight confidence in our business and cash flow, and we aim to boost cash reserves over time.

We are at time now, but I see there are a couple more people in the queue. We'll take two more questions quickly.

Thanks, Alan.

Our next question comes from Patrick Walravens with JMP. Please proceed with your question.

Great. Alan, do you have sufficient PhD-level AI talent to meet your needs? You have Peter van der Putten and Christian, but how much more do you need?

I also have Rob Walker, a great PhD, and several others who, while not PhDs, have the talent for AI. I'm confident in our talent base in this environment.

Can we get an update on the lawsuit? Whatever you can share?

We're currently in the appeal-waiting process, and I look forward to presenting our case.

All right. Great. Thank you.

Thank you, everyone. We are working very hard for you. We're generating cash, which Ken and I are thrilled about. We'll continue keeping you updated. Take care, everyone. Goodbye.

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