Pegasystems Inc Q3 FY2023 Earnings Call

Greetings, and welcome to the Pegasystems Third Quarter 2023 Earnings Results Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Peter Welburn, Vice President, Corporate Development and Investor Relations for Pegasystems. Please go ahead.

Thank you, Priscilla, and good morning, everyone, and welcome to Pegasystems Q3 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 2023 and beyond could differ materially from the company's current expectations. Our press release announcing our Q3 2023 earnings and our SEC filings, including our most recent annual report, describe factors that could impact our results and cause them to materially differ from those expressed in forward-looking statements. Investors should not place undue reliance on forward-looking statements; matters contained in forward-looking statements may not occur. Later events, new information or other factors may cause our views to change, but we will not publicly update or revise forward-looking statements unless required by law to do so. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Peter, and to everyone who's joined today's call. It's great to see us improve performance in an uncertain macroeconomic environment. Now more than ever, we are focused on running a business that balances growth and free cash flow. And it's especially good to see record cash flow as we come out of our subscription transition, and we're just getting started. Ken will go into more detail on our financial results in a moment. As I mentioned last quarter, we've been finding additional ways to engage effectively and efficiently with our clients. The transformation of our go-to-market model is delivering on our goal of deepening client relationships. This helps drive more meaningful engagement across multiple teams as those relationships strengthen. I was excited to spend most of Q3 on the road, meeting with clients, prospects, and partners globally. Coming off the tremendous momentum from PegaWorld and the launch of Infinity '23, it was terrific to spend this direct time with these constituencies. I had around-the-world trip, and it was good to see folks I had not had a chance to see at PegaWorld. I met face-to-face with over 100 clients and partners and had terrific conversations across the board, across the U.S. with Amazon, Bank of America, UnitedHealth Group, and even in India with Verizon where they, like many of our clients, are establishing global competency centers, and we're having a chance to engage our Indian team directly with them. Going down to APAC with ANZ Bank, National Australia Bank, multiple government agencies across APJ, and in London with HSBC, Lloyds and Vodafone. As well as with the thousands of our partners around the world, including Accenture, Capgemini, Cognizant, EY and Infosys. Our U.S. briefing center continues to be extremely busy this year. We've had hundreds of meetings with clients like ING, Mondelez, Navy Federal Union, and Scotiabank where their staff have really come in to do a deep dive on topics ranging from Pega Strategy to Pega Cloud. We have many more plans for Q4. In Q3, we kicked off a series of account-based marketing client events to continue the momentum of PegaWorld with 75 regional and specific client events, and we're going to have even more before the end of the year. I'm really enjoying being back on the road in a significant way. I'm terrifically excited about the level of engagement and dialogue we're having. Even though you can accomplish a lot remotely, meeting in-person provides a different opportunity to dig in and understand what's top of mind for our clients. As I have done this, I have had a chance to really hear firsthand what the client interests and questions are about what Pega can do and whether Pega has a unique advantage in this product environment. What I'll share is that AI, no surprise, has become central to nearly every client conversation. Their questions are falling into a few categories. First, what should their AI strategy be? And where does Pega fit? Second, how can they protect and govern their proprietary customer data? And third, how can they address the risks associated with GenAI, particularly hallucinations where the AI provides a response not backed up by data or best processes? Pega's technology experience gives us a unique competitive advantage in this view. Let me elaborate. First, in terms of strategy. We have decades of hands-on experience helping clients leverage AI, and we can use it to help them with their strategy. We have terrific insights into the most successful early use cases for GenAI, which we believe will deliver the highest return on investment. We're showing them to our clients and getting tremendous positive feedback. One of the best things that I encourage all of you to try is this interactive demo on pega.com that shows how we have linked generative AI into the core thinking of how Pega workflow should work, and how it's going to help you create all the necessary elements using the knowledge of the Internet to bring best practices into a business. You'll see within seconds the workflows, the users, the data model, and the other key elements identified. We launched it when Pega Infinity went live in mid-September. And in the first month, thousands of people from around the world accessed the demo and did over 6,000 workflow generations, from employee onboarding to a cricket scoreboard generator. I would suggest that anyone interested in understanding how this can be done practically go to pega.com, take the interactive tour we have or just search for GenAI and check out the interactive demo, which is what I've just been discussing. Try building an app for your current firm or a business that you've been thinking about starting when you retire. I think you'll share the excitement of how Pega is in a position to really bring this technology home in a very unique way. A lot of clients have gotten very jazzed and interested in this. You can even try it on your mobile phone, and it's also quite a good demo there. So when customers see what we are able to do, especially what we are shipping in Infinity '23, we get a very positive reaction in terms of how we can add powerful and pragmatic capabilities to their businesses. In terms of where Pega fits into their strategy, it's important to remember that while most companies think about GenAI as a cogenerator, Pega is core based on a business model that brings a structure and system that can evolve as the client needs, the industry needs, and customer needs evolve. Instead of just code, with our GenAI, we generate business logic into a model that organizes the business objectives and allows the AI to be understood, reviewed, adjusted, curated, and approved. The center of this is what you've heard me refer to as our unique situation layer cake. This organizes the way a business runs into layers, with some elements operating across the business as a whole, some on the division, some perhaps within departments, and some for different customer segments or geographies. This unique structure organizes all the enterprise assets, the processes, the rules, data models, and UI into these layers designed for business units. This architecture is perfect for utilizing GenAI, and it provides Pega a unique and significant advantage because you'll plug GenAI in when the rules and workflows are defined. It allows for changes within your business or workflow, with a governance structure that ensures manageable transitions. This process allows AI output to be organized in a way that truly helps businesses build for change, and it's proprietary to Pega; I don't think it can be readily copied or reproduced, and we don't see anyone else taking this approach. We're excited about what this means for us. We have also created around 20 GenAI boosters with Pega Infinity that make GenAI practical and real, and you can also find those described at pega.com. Secondly, regarding data, we will be able to help clients protect and govern customer data through our software's powerful capabilities. Pega's audit trail capabilities, described as the best in the industry, are robust and comprehensive. Lastly, we address GenAI risks by leveraging a platform designed to help customers deploy their processes and their AI effectively and responsibly. Customers can see what's happening, identify where AI is working in their models, and understand when the AI makes sense versus when it generates nonsense. Our robotic capabilities also help clients confirm that the data powering AI decisions is unbiased and comprehensive, using our unique ethical bias check that identifies and eliminates biases hidden in AI, flagging any potentially discriminatory offers and messages generated by AI before they reach the customer. This unique capability helps clients pinpoint offending elements and adjust algorithms for fair outcomes. Client responses to this have been very exciting and inspiring. It’s wonderful to see our clients now beginning to work on this. As we enter 2024, we'll complement what we've already released in '23 with an extensive pipeline of features that will continue to extend these game-changing capabilities and leverage our unique architecture. Before I wrap up, I want to provide a quick update on Pega Launchpad, our new cloud-based low-code application development platform for building business-to-business SaaS applications, which we announced last year. It's a gorgeous piece of software, and the team has done a tremendous job focusing and supporting our early adopters, and we now have our first handful of Launchpad clients. We're really excited to ramp this business up in 2024 and beyond. In summary, we continue to improve our performance. As we come out of our subscription transition, we see improvement in cash despite the uncertain macro environment. The transformation of our go-to-market model is enhancing our sales efficiency and engagement while focusing on deepening the critical relationships that drive our business. Our unique technology architecture is a competitive advantage that allows us to leverage GenAI in a manner that I don't see our competitors easily replicating, resulting in a significant and lasting distinction. We are making good progress in becoming a Rule of 40 company, balancing growth with fiscal discipline, and now let me turn it over to our COO and CFO, Ken Stillwell. Ken?

Thanks, Alan. Through the first three quarters of 2023, we've made meaningful progress improving our cash flow while maintaining double-digit ACV growth. We're managing the company with a Rule of 40 mindset, the principle that in a well-run firm, the growth rate and free cash flow margin should meet or exceed 40%. I've got some exciting news to share later on the call regarding our free cash flow. I’m going to start this morning with the most important metric to measure the success of our business—growth in annual contract value, or ACV. This year, we've experienced a macroeconomic environment that’s not noticeably worse than last year, but it's certainly not much better. Our clients are still buying, but they're scrutinizing things more closely. Sales cycles are a little longer than they've been for the last few years. Despite that, our sales team delivered a good Q3 with significant contributions from EMEA and our financial services clients. Through the first three quarters of 2023, total contract value bookings increased by about 20% year-over-year. I think that's an important measure to complement our ACV and backlog performance. Given the strong level of activity we experienced in Q3, our new go-to-market strategy is clearly leading to deeper engagement with our clients. As a result, ACV grew 12% year-over-year, with currency helping our growth by around 2%. Like numerous other companies, we received an SEC comment letter related to standardizing our free cash flow measures. The more traditional way to calculate free cash flow is to take cash flow from operations and subtract capital expenditures. Going forward, this is the approach we will use. We will not add back one-time cash items such as restructuring charges to calculate adjusted free cash flow. However, we will continue disclosing items in our earnings release that we believe are not representative of our ongoing operating performance. Over the first three quarters of 2023, Pega generated $138 million of cash flow from operations and $124 million of free cash flow. In Q3 alone, we added $24 million of free cash flow. The $124 million is the highest amount of free cash flow dollars generated in the first three quarters of the year in the history of the company. We increased our cash and marketable securities by $60 million year-to-date, alongside our almost $100 million of convertible repurchase. As we outlined during our most recent investor session at PegaWorld in June, our multi-year plan to improve free cash flow features three key levers. First, we need to expand total gross margin. We're confident we can continue to expand total gross margin by scaling our Pega Cloud business, increasing cloud automation, and implementing Kubernetes and multi-tenancy. Our most recent results confirm that we're making progress. In Q3, on a trailing 12-month basis, non-GAAP total gross margin increased to just over 74%, a 129 basis point improvement year-over-year. Our key driver of gross margin improvement is non-GAAP Pega Cloud gross margin, which increased 430 basis points from 69% to just under 73% on a trailing 12-month basis. Another lever to improve our free cash flow is to enhance sales efficiency, which we view as the most important of the three levers. As you know, we made the difficult decision to reduce our headcount in the last year, with most reductions coming from the sales and marketing organization. It's difficult to deliver double-digit growth while also improving sales efficiency. We spend more than $0.5 billion annually on sales and marketing. That's a significant expense, and we need to ensure that we leverage that to drive our growth. The last lever to improve our free cash flow is enhancing our operating leverage by managing total costs, including general administrative and R&D, making sure that those grow at a slower pace than our ACV growth. At our company size, we should exhibit operating leverage. Over the last year, we've simplified our go-to-market operations. In software companies like ours, complexity often hampers sales efficiency and effectiveness. We've eliminated management layers, clarified team roles, and focused our sales team on cross-selling and up-selling into existing clients, ensuring that all our teams are aligned. These actions are helping to improve our sales efficiency, which you can see reflected in our financials. On a non-GAAP basis, total sales and marketing spend as a percentage of revenue declined from 47% to 38% year-over-year in Q3 on a trailing 12-month basis. Our focused execution on balancing growth and profit is positively impacting our profitability, generating $124 million of free cash flow in the first three quarters of 2023 compared to a negative free cash flow of $36 million generated in the same period last year. I've also got good news regarding our free cash flow trajectory going forward. Based on year-to-date results and our global team's successful execution, I'm confident we have a shot at delivering more than $200 million of free cash flow in 2023. I'm excited that our team is positioned to deliver the highest annual cash flow in the history of the company, and Q4 is typically our strongest cash flow generation quarter of the year. To be clear, we do not update guidance quarterly, and I'm not creating any precedent or officially updating free cash flow guidance for 2023, but I wanted to share my thoughts on our trajectory as we approach the completion of this year. In prior calls, we shared thoughts on modeling our business, and we've received feedback that this practice is helpful. So I've decided to reinforce that today. First, regarding free cash flow, I recognize that making a change in how we present free cash flow might be considered somewhat unusual. So we've added a table in our earnings release to show free cash flow quarterly, just to aid in your modeling. The table also separately discloses items that affect our cash flow, which management considers not representative of core business operations, such as restructuring costs. Our prior 2023 annual free cash flow guidance included these adjustments, and going forward, our guidance will be consistent with a more conventional methodology. Lastly, we closed more term license deals this quarter than is typical. Our term license bookings are usually strongest in the first and final quarters of the year, so a strong term license booking result in Q3 is not typical, however, we view growth in ACV as the most critical measure. Clients sometimes decide to use client cloud instead of Pega Cloud, and we will support whatever decision they make. We've made progress this year on improving our cash flow while maintaining a double-digit ACV growth rate amidst a more uncertain selling environment. Our team is embracing a Rule of 40 mindset and doing a much better job of managing the trade-offs between growth and profit. The world’s greatest software companies achieve the Rule of 40 not only in a single year but do so consistently over sustained periods. That’s our objective—to balance growth and profit over the long term, and we look forward to closing out 2023 strong. As I wrap up today, I wanted to announce that our annual investor session will be held on Monday, June 10, at the MGM Hotel in Las Vegas, during PegaWorld. Please mark your calendars. I look forward to seeing all of you on the road as we get out to meet current and potential investors in November and December. One last point: the date for our oral argument in our Virginia appeal is now scheduled for November 15. Although it will likely be months until we know the result, it’s great to have the appeal scheduled and in front of us. With that, operator, please open the call for questions.

Our first question comes from Steve Enders with Citi.

Maybe to start, I just want to get a better understanding for—when you talk about the uncertain macro and that kind of continuing, what that actually looks like in terms of the deal environment that you're seeing out there? And maybe how are things changed so far in October from the conversations and the deal environment that you're seeing today?

Yes. I would say that the mood in many clients has, for the last year admittedly, been more questioning. It’s entirely consistent with organizations doing a better level of scrutiny than when money was free. Organizations are respecting businesses that can deliver profitability. They are checking types of deals more thoroughly, which leads to slightly longer sales cycles. However, I am not seeing anything troubling as we enter Q4. Customers really want to set their businesses up for success in 2024. Many clients see us as central to their ability to gain real efficiencies, which is not around the cost of software but more about optimizing their operations and improving their engagement. We’ve been through many recessionary periods, and during tough market conditions, organizations adapt, focusing on delivering tangible results for clients rather than simply generating revenue.

No, definitely. There's helpful context there, especially for the 4Q view. I appreciate the commentary. Shifting gears to the sales and marketing changes and initiatives: What has been the feedback from customers regarding the impact that could potentially have on productivity and efficiency? Additionally, how should we think about the cash flow impact from those changes going forward?

Let me tackle that. We made some organizational changes in the last few months, which are never easy, and we have a lot of empathy for those affected. Those changes have not resulted in any improvement in free cash flow yet, and they will likely have minimal impact, if any, in Q4. However, there will be a full-year impact in 2024. I want to clarify that when I referred to achieving $200 million in free cash flow, I'm referring to our new, more traditional measure. Adjusting for one-time items would yield a significantly higher number, so I wanted to clarify that as it may have appeared vague.

I want to emphasize that we worked hard so that we could enter Q4 with the changes behind us. We’ve done that, and we expect to be in execution mode moving forward.

Our next question comes from Pinjalim Bora with JPMorgan.

Can I ask you about the term performance? What drove that? Was federal part of it, or anything else to call out? Secondly, on cloud ACV growth, it seems to continue to decelerate. I hear your point on overall ACV growth being more significant. But as you launch Infinity '23, which adds many GenAI capabilities on the cloud side, should we expect cloud ACV growth to trough at some point going forward?

Great question. The stronger term performance is typically driven by higher percentages of new workloads or applications where clients may already have existing relationships with us. However, when clients expand existing workflows, they tend to go for Pega Cloud. This isn't a change in strategy; it’s a reflection of how clients engage with us based on new projects. In terms of the cloud ACV growth, I think we might see increases in rates as we enter Q4 and into early 2024.

I would echo that based on the current market vibrations. I’d be surprised if cloud growth doesn't see a pick-up in the next couple of quarters.

Yes, exactly. The difference in term licensing tends to be influenced by clients looking to increase their spend in renewal periods, which can occur in other quarters as well.

Just to clarify, for this quarter in terms, were there any large deals that swung the numbers positively, or was it...

No, it wasn't skewed by large deals in Q3. Our approach has transitioned more towards consumption-based revenue, typically generating more repeatable growth rather than relying on a few large shock deals.

Our next question comes from Jake Roberge with William Blair.

Alan, when you're talking to customers, where are the dollars for AI spending coming from? Are they coming from existing IT budgets and potentially crowding out other expenditures? Or are you seeing customers create net new budget dollars to account for those investments?

We're seeing both scenarios. We are happy to see innovation budgets starting to roll out. A client announced a few days ago they were putting several hundred million dollars into their innovation budget, which is a fantastic sign. These investments are helping clients alleviate traditional spending, but they're looking to make substantial changes in their business over the next couple of years and don't want to risk falling behind.

Very helpful. Ken, do you still feel Pega is on track to complete the subscription transition this year? Given constant currency ACV growth ticked down to 10% this quarter, how should we consider the balance between growth and margin to reach those targets?

We do believe we’ll complete the subscription transition this year. In fact, we might say it’s already complete now, given that perpetual license bookings have been under 5% for about four years. The business has normalized much more now; variability is expected quarter to quarter. However, I would say the consistency and predictability in our billing are restored. For the exit of 2024, I sense that cash flow will be significantly higher than growth, even presently. We’re aiming to end up in a strong position for growth as a mid- to high-20s free cash flow firm in 2024.

Our next question comes from Kevin Kumar with Goldman Sachs.

Alan, you called out EMEA in your script. Can you expand on the health of the customer base in those regions and the overall macro environment there?

EMEA was looking a little tepid a couple of quarters ago. I'm pleased with the progress made during my last visit. I'm returning in Q4 because we are seeing revitalizing trends. In most countries across EMEA, conditions are improving, with some areas performing better than others, such as the U.K. which is facing political transitions, despite interests aimed at improving profitability.

Can you provide an update on the government vertical? What use cases are you best positioned for and what is the level of deal activity you're seeing there?

We're observing substantial activity in the government vertical. We recently hired Jen Pratt as a senior executive specifically focusing on this area, and I'm very encouraged to see her quickly ramping up. Our bellwether clients include the IRS, FBI, and Department of Justice, all are facing significant needs for improvement. We're handling serious workflows characterized by their need for extensive data management over extended periods, ideal for government applications. Automation, auditing, and enhancing citizen engagement remain crucial focus points, especially in the current climate across all regions. I'm excited to see what we're doing in various regions—government systems in Singapore and several projects in the U.K. and Germany demonstrate considerable potential.

The government vertical traditionally leans toward retaining legacy applications but is eager to modernize at the user layer, which aligns with Pega orchestrating and interfacing with embedded systems that need continued operation.

Our next question comes from Rishi Jaluria with RBC.

Can you help us understand what you are seeing in terms of customer sentiment regarding large-scale digital transformations? Partners have mentioned that customers may be hesitant to move forward due to the uncertain macro environment. However, as they contemplate their generative AI strategies, integrating workflows becomes increasingly important. What is your takeaway here?

It's a valuable question. I see a couple of parallel trends here. When the macro environment shifts to cautious, organizations insure their investments are practical and yield tangible results. Pega is well-equipped for such scenarios; we've steered the conversation away from merely boosting revenue to helping clients enhance decision-making and workforce management to get work done effectively. The buzz around generative AI is present, but so are many uncertainties; clients are still experimenting and learning. However, they seek to understand how to practically integrate generative AI to drive measurable outcomes, and we are getting a lot of excitement from clients about what we can offer.

On the gross margin front, how should we forecast terminal gross margins on the cloud side? Could this provider achieve an 80% cloud gross margin business, or are there structural challenges inhibiting that?

With a level of optimism, we definitely see a path to achieving 80% gross margins in the future. When Pega Cloud first started, we hoped to hit 70%, but once we neared 65%, we aimed for 75%. Now that we are close to 75%, 80% is the target ahead. The journey might be easy or may present unexpected challenges, but we remain committed.

Our next question comes from Raimo Lenschow with Barclays.

The transition towards term licensing was much better than the cloud. As we move through this downturn, do you plan to concentrate more on the cloud or maintain your current approach regarding client preferences?

We remain fully committed to Pega Cloud and its expansion. However, we acknowledge clients' journeys to cloud solutions may vary in pace due to operational needs. We intend to support our clients as they navigate this transition while focusing on scaling and modernizing Pega Cloud.

I'm looking forward to how AI will impact our operations over the long term. We will leverage new technologies that I believe can greatly increase productivity and enable us to deliver results faster and better. Additionally, we view AI as a means to enhance both Pega's effectiveness and customer operations going forward.

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

Alan, do you see generative AI attracting a new type of customer to the company?

Absolutely. We are seeing a new type of buyer inside customers engaging with us on AI projects. This expands beyond traditional technical sales to include business buyers. The tools we offer, like the generative AI demo, attract substantial interest from those managing practical problems. For example, a large U.K. bank asked about processes to close politically exposed accounts. We are seeing substantial engagement with a whole new area of buyers.

The sales team underwent organizational changes that focus on getting selling resources closer to clients, and we aimed to ensure we have a unified mission across roles. This change is intended to improve efficiencies and decrease complexity in our sales operations.

Our next question comes from Joe Meares with Truist Securities.

Are you planning to enhance reliance on partners after reducing sales and marketing headcount? Additionally, with the expected free cash flow exceeding $200 million this year, are you moving closer to your $500 million target?

I would not say we are replacing the reductions in headcount with partners, but we are emphasizing the importance of partner engagement more. Partner relationships are vital, and we want to maximize our effectiveness. Regarding savings, the impact from our changes can lead to annual run-rate savings of approximately $60 million to $70 million. $500 million is still a long-term target that we remain focused but acknowledging it's still a few years away.

Correct. The simplification of management structures significantly aids in delivering efficiency while maximizing partner engagement. We feel confident about the planning and execution moving forward.

Our next question comes from Fred Havemeyer with Macquarie.

Are you seeing any shifts in priorities among your partners related to generative AI implementation?

Our partners are keenly aware of the significant opportunities presented by generative AI. Many are undergoing transformations to how they deliver projects, prompting an immense amount of opportunity. We are collaborating with partners on innovation agendas to capitalize on potential and help them understand the games ahead.

Our next question comes from Blair Abernethy with Rosenblatt Securities.

Ken, could you comment on the renewal environment in Q3? What should we expect moving into Q4 given the macro conditions?

We haven’t seen any noticeable changes in client renewal rates—they overall are willing to stay and invest with us. Unfortunately, some clients may pursue different directions, which happens across software companies, but 2023 has not seen significant shifts.

The discussions of macro conditions do not correlate with our renewal environment. Our clients represent larger, more stable entities with a focus on driving their businesses forward rather than squeezing vendors.

Historically, our focus on net new workloads has been more affected than existing applications, which tend to maintain a constant growth.

Regarding the risks of AI, we have a strong understanding and approach to managing this. For instance, we develop opportunities for the right individuals to curate AI's output, ensuring accuracy. Additionally, we work hard to eliminate those noticeable data response hallucinations through our best practices, solidifying trust with clients. Moreover, our bias-checking capability plays a key role in ethical AI considerations.

This concludes today's conference call. You may disconnect your lines at this time. Thank you for your participation, and have a great day.