Pegasystems Inc Q4 FY2023 Earnings Call

Good morning. My name is Jeannie and I will be your conference operator today. I would like to welcome you to the Pegasystems Q4 and Fiscal Year 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you. I would now like to turn the conference over to Peter Welburn, VP of Corporate Development and Investor Relations. You may begin your conference.

Thank you, Jeannie. Good morning, everyone, and welcome to Pegasystems Q4 and Full-Year 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 2024 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 Q4 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, 2023 and other recent filings with the Securities and Exchange Commission. 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 change 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 turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Peter, and to everyone who's joining today's call. It's terrific to see how well the team performed in 2023. The organization responded to our new go-to-market strategy, and we finished the year with a very strong Q4. We continue to deepen and expand our client relationships. We've been doing a terrific job, I think, of applying Gen AI to introduce innovative industry-changing technology. And we generated a good mix of growth and cash flow, which Ken will discuss in more detail in a few minutes. This year continued the important themes we've been talking about. And I'm more convinced than ever, there's still amazing opportunity for growth within our client base. And I'm confident in our organization focused deep engagement model. I continue to engage with our most senior clients, most recently in Davos for the World Economic Forum annual meeting. I talked to dozens of C-suite clients and partners about how they're responding to change, their business opportunities, the challenges, and plans for 2024 and beyond. AI is still central to almost every client conversation, as they continue to try to understand and explore where and how to leverage AI effectively and safely in their organizations. And we're showing them how Pega can help. These conversations reinforce for me that what we have is unique and perfectly suited to enterprise needs. I couldn't be more excited about the incredible opportunity to leverage Gen AI and revolutionize the way clients use our technology to drive success in 2024 and beyond. Let me tell you why Pega is perfectly positioned to help clients deliver on the Gen AI opportunity. Since our founding, we've been incorporating the principles of AI generally, statistical as well as in our generative, into our offerings and really focused on building products designed for the needs of the sophisticated enterprise. Our clients come to us because they want to transform their businesses, become more efficient, more profitable, or improve loyalty, creating better experiences for their customers and employees. And our enterprise AI decisioning and workflow automation platform enables clients to unlock business-transforming outcomes, with real-time optimization and continuous improvement. You can find great case studies on our website that explain how our clients are using the software to improve customer engagement by customizing conversations in real time and at scale. For instance, Wells Fargo describes how they're using our customer decision hub to provide targeted and relevant responses to the billions of interactions they receive monthly from customers. Secondly, to enhance client service through AI-powered guidance that delivers amazing experiences for customers and employees, boosting loyalty, supporting retention, and driving down costs. Aflac describes on the website how we're simplifying and automating the processing of thousands of emails per week and reducing resolution time, improving customer and employee satisfaction. And finally, what we've always done, streamlining operations by automating operations with intelligence. This is what Lloyd's talks about, automating their business processes to resolve fraud and dispute cases faster and more effectively, even while on the phone with the client. These results are what matter to our clients. They're looking to transform their businesses, not simply crank out more code. So when we apply Gen AI, we're not using it to generate code. We're using it to optimize the business concepts, adhering to best practices, for example, suggesting the most efficient and effective way to process a mortgage or insurance claim or how to create the best offer and marketing treatment for our client. We have a unique structure built around business concepts and enterprise process rules, data models, and user interfaces; all of those are organized into layers so they can be built on, reused, and specialized to support the needs of different product lines, customer segments, or geographical jurisdictions that an enterprise might need to manage. This layered architecture is the perfect architecture for Gen AI, and I believe it's Pega's unique advantage because we use Gen AI not to write code but to directly author and control the business concepts themselves. This unique layer cake architecture has enabled us to develop, integrate, and deliver new Gen AI capabilities and services very quickly, and it's based on a patented architecture that we've studied and evolved for decades and can't readily be copied or reproduced. I think this gives us a clear competitive advantage. In terms of our strategy for this year and next, there are four major areas we believe our approach to Gen AI will drive a massive impact for our clients and for Pega. First, we're looking to double developer productivity in Pega, with Pega skills always at their fingertips. Second, we're looking to ignite enterprise innovation by bringing together industry expertise, Pega technology, the wisdom of the internet, and our clients' insights. Third, we're looking to try to maximize revenue and efficiencies for our clients by giving them real-time optimization and personalization of customer interactions and enabling them to continually optimize. And finally, we aim to streamline work processes and customer experiences by providing the right people instant access to the right real-time systems and capabilities, so they can literally get the work done. Let me tell you how we're delivering on the strategy today and what to expect in the future. We started by introducing 20 Gen AI boosters as part of Pega Infinity '23 in the fourth quarter, supporting our goal of improving developer productivity and showing our clients how these tools can be used safely and responsibly. We launched an interactive demo on our website that lets clients immediately experience the power of our Gen AI capabilities. You can describe a business process you want to optimize, and Pega Gen AI helps you design the optimal processes, the stages, the steps, the data model, the user personas, all in seconds. It's available to all of you. Since its launch, thousands of visitors have experienced the demo and gone through workflows from client onboarding to 5G network rollout, and we're hearing terrific feedback. I encourage you to try it yourself. In the last few weeks, we announced two new powerful offerings that I think are going to be game-changing. The Pega GenAI Knowledge Buddy and the Pega GenAI Blueprint. The Knowledge Buddy is an enterprise-grade generative AI-powered knowledge assistant to quickly and easily help customers and employees get specific answers based on a company's own content. Since it's synthesized by generative AI, employees don't have to search across siloed and scattered knowledge bases. Now, there are lots of Gen AI-based assistants in the market that ingest content or answer questions. But we believe that they're generally not built for true enterprise needs. So we've designed a product that is fortified with enterprise-grade integration, auditing, and controls. It puts organizational knowledge at employees' and customers' fingertips, allowing them to ask questions through simple conversational interfaces and get specific, accurate, and concise responses with transparent attributions to where the source content is coming from. We're using Knowledge Buddy to embed all the Pega documentation and support library into our design environment, so developers can easily find answers about how Pega can make them more productive and operate faster with less training. This powerful combination of our innovative AI architecture with security features means that our clients can use this latest technology and feel confident and safe, knowing they're adhering to high standards of trust and responsibility. Just a few days ago, we announced what I think will be truly remarkable as it develops; it's the Pega GenAI Blueprint. This is a collaborative SaaS application that automates enterprise-grade workflow application designs to catalyze enterprise innovation and significantly increase developer productivity. I'm going to ask Kerim Akgonul, our Chief Product Officer, to tell you about this groundbreaking product. Kerim?

All right. Thank you, Alan. GenAI Blueprint is very exciting. It really stems from the fact that we all know that traditional design processes are often unsuccessful and are always very time-consuming, mostly because they don't really stimulate design thinking, they don't drive a vision, and they don't really drive stakeholder alignment. These days, most generative AI approaches focus solely on churning out software code. They're not focused on organizing outcomes or driving business alignment. But Pega GenAI Blueprint is entirely focused on driving incredible outcomes with amazing speed for enterprise applications. It combines Pega's robust library of industry expertise and process templates with general internet knowledge. It uses generative AI to synthesize all of that information and automatically recommend best practice workflows, data models, and more, all just from an application name and brief description. We even get to layer in a client's best practices to ensure effectiveness and reuse. There is absolutely nothing else like this in the market today. Business leaders across every industry can rapidly capture their vision and even rethink their business processes to drive innovation in their organizations, sparking brand new ideas that they wouldn't have thought of on their own. This interactive application blueprint it generates is easily understood and collaborated on by all stakeholders to drive alignment. It can take blueprint suggestions and alter them to meet their needs. Once agreed to, they are ingested into Pega to generate the enterprise-grade cloud-architected applications. This is how you can leverage Gen AI to actually drive transformation in the enterprise. When you get a chance to see this product, you'll be astonished at the speed of innovation and how widely applicable it is across every industry and geography. The response from our early adopter clients and partners has been incredibly positive for their specific use cases. What's important is that Pega GenAI Knowledge Buddy and Pega GenAI Blueprint will help our clients and partners more quickly and easily learn how to build Pega applications. Since Pega has always been known as one of the most powerful platforms for creating applications, we're now significantly reducing the barrier to entry and speed to value by making it much more accessible. We've just really scratched the surface of what Gen AI can do. These new products are the start of a series of exciting offerings that we'll be presenting between now and PegaWorld on June 9 that will continue to deliver on our strategy. I'll turn it back to Alan.

Thanks, Kerim. It's very exciting. And we're very excited to be going back to Las Vegas again this year for PegaWorld from June 9 to June 11. Please mark your calendars. We have an exciting lineup of clients who are presenting. For example, National Australia Bank will be featuring its groundbreaking initiatives using the customer decision hub to drive value for the bank and its customers, developed and into production in under six months. Verizon will be talking about how it permeated selling into all its customer-facing teams, delighting customers by leveraging deep intelligence about the client, marketing science, and real-time signals. So check out the agenda on pega.com to see the dozens of other great client stories you'll be able to hear about in person and talk to the customers directly. And of course, we'll be talking about and showing our newest innovations and what to expect for the rest of the year. Now we've scheduled our investor session for Monday the 10th at noon local time. We hope to see you then, if not before. I'll be joining Ken to meet with some investors here while on the road visiting clients. So keep an eye out for an invite and be sure to register. It's going to be tremendous. In summary, we're delivering transformative innovation to truly change the way the world builds software. I'm pleased that our go-to-market and organization-focused model is working, and our focus on balancing growth and profitability is evident in our results. I believe we have a competitive advantage through our architecture, and we're going to be able to leverage Gen AI to bring significant value to clients in a way our competitors can't easily match. There's a tremendous opportunity for growth in 2024 and beyond. To provide more color on our financial results, let me now turn it over to Ken Stillwell, our COO and CFO.

Thanks, Alan. Pega has truly entered a new financial frontier. We finished the year with extremely strong growth in free cash flow and a nice re-acceleration of Pega Cloud ACV. In the 40-year history of Pega, we've never seen the level of cash flow generation we experienced in 2023. Quite frankly, we're just getting started. The shift to a new subscription business model provides us with improved visibility, allowing us to better manage the operating efficiency of the firm and drive superior cash generation. That dynamic, coupled with our strong go-to-market execution in the fourth quarter of 2023, resulted in impressive results in a challenging market. Annual contract value, or ACV, continues to be the most important metric to measure the success of our business. The ACV growth in constant currency accelerated in Q4, growing by 11% year-over-year. Our double-digit ACV growth was powered by an extremely strong net new ACV add in the fourth quarter. In fact, our sales team put more net new ACV in Q4 of 2023 than it did in Q4 of 2022, a clear indication that our new go-to-market strategy is working. The surge in net new ACV came from an extremely strong growth in Pega Cloud. We added $58 million in Pega Cloud ACV in the fourth quarter alone, the highest of any quarter ever. As a result, Pega Cloud ACV growth re-accelerated in Q4 to 21% year-over-year. It's just awesome to see. Pega Cloud is now our primary offering that clients are demanding as it enables our clients to focus on developing innovative business applications on the Pega platform without having to manage an underlying cloud infrastructure. It helps keep our clients current on the latest and greatest Pega technology, which is also a tremendous benefit. Moving on to revenue. We achieved total revenue of $1.43 billion. Revenue growth was driven by two key factors. First, 2023 had a larger number of term renewals than in 2022. Second, we had a handful of clients in Q4 who chose to renew term license contracts for longer durations than we forecast. Under ASC 606, as many of you are aware, a significant portion of multi-year term license bookings are recognized as subscription license revenue in the quarter the deals are booked. Moving to cash flow. Cash flow from operations was $218 million, an increase of over 800% from the prior year's total of $22 million. Free cash flow surged year-over-year to $201 million, once again the highest free cash flow in the history of the company. This strong increase demonstrates the core strength and completion of our subscription transition and the team's success in managing operating costs. We achieved this amazing number, even though we had over $50 million in items like restructuring and legal costs. We expanded non-GAAP Pega Cloud margin from 70% to approximately 75%. We also improved operating leverage across all three operating expense lines. We reduced non-GAAP sales and marketing expense as a percentage of total revenue from 43% to 35%, making the very difficult decision to execute two reductions in force in 2023. These two actions brought together our sales and client success teams, reduced operational silos, and focused our teams on cross-selling and upselling into the existing clients. Capital expense also normalized since we completed the build-out of our Waltham, Massachusetts office. Moving on to earnings per share. Full-year GAAP EPS came in at $0.73, and non-GAAP EPS was $2.48. Non-GAAP EPS exceeded $2 per share for the first time in the company's history. Many of the same factors that powered our strong cash flow growth were key drivers in our year-over-year improvement in EPS as well. I'm really happy with our double-digit ACV growth and our robust increase in free cash flow. We wanted to exit 2023 as a rule of 30 company, which we've done. We define the rule of 30 the same way we define the rule of 40; that is, the combination of our ACV growth, plus our free cash flow margin, adjusted for any items like restructuring, legal fees, interest expense, and taxes, essentially making it an EBITDA-like equivalent measure. Achieving the rule of 30 demonstrates the progress we've made in instilling much greater operational rigor and performance transparency in our business. Moving to our guidance for 2024. As a reminder, we provide annual guidance at the beginning of the year, and we do not typically update annual guidance unless we do a material acquisition. We do not provide quarterly guidance. Starting with our growth metrics for 2024, we expect ACV to grow 11%. We expect total revenue of approximately $1.5 billion. Revenue growth will be slower than ACV growth in 2024 because we have a slightly lower mix of multi-year term license renewals, and we're modeling an uptick in cloud-based bookings as clients continue to buy Pega Cloud as the primary offering. Moving to our profitability metrics; we're guiding cash flow from operations to $365 million. We're forecasting free cash flow to increase about 75% year-over-year to $350 million. We expect GAAP EPS of $1.18 per share and non-GAAP EPS of $2.75 per share. I've received feedback that it's helpful when we share thoughts on modeling our business. So I'll continue to offer a few suggestions, starting with ACV growth. We expect ACV growth to be back-end loaded in 2024. As we experienced in 2023, many of our existing client contracts are up for renewal at the end of the year. Since we plan to focus our go-to-market motion on cross-selling and upselling into our existing clients, we expect to see a significant portion of our net new ACV that gets added in the final quarter of the year. This is very common for enterprise technology companies. In the environment that we've seen in 2023 and we predicted for 2024, we will continue to see a significant amount of transactions that tend to happen towards the end of a buying cycle or a fiscal year. Given that we've added such an unusually high amount of net new ACV in Q1 of 2023, we face a very tough ACV compare in the first quarter of 2024. As a result, you should expect that our ACV growth rate will slow a little in the first quarter and then bounce back in the later part of the year. Moving to term license revenue, we expect total term license revenue to decrease year-over-year in 2024 as existing clients and new clients choose Pega Cloud. We also have a slightly lower number of multi-year renewals coming due in 2024 than we did in 2023. We expect to book shorter-duration term license contracts as more of our clients value the consumptive nature of their growth. Under ASC 606, a shorter-duration term license contract results in less term license revenue booked upfront than a traditionally longer-duration contract. However, more frequent contract renewals provide us with a greater opportunity to cross-sell, upsell, and support and assist our clients as they move to Pega Cloud and initiate new workloads and use cases on Pega Cloud. Next, I want to remind you that PegaWorld, our annual client and partner event, as Alan mentioned, will be held from Sunday, June 9 through Tuesday, June 11 at the MGM Grand in Las Vegas. Please mark your calendars. We'd love to have you join us in person as you have in previous years. Our annual investor session is planned for Monday, June 10 during the PegaWorld session. In addition, we'll be on the road at several sell-side conferences in March, as well as a few NDRs. We look forward to catching up with all of you soon. In conclusion, we've focused on providing outstanding experiences and value to our clients and believe that well-managed firms drive responsible levels of free cash flow for their shareholders. As we've demonstrated in 2023, we're very focused on balancing growth and profitability and made outstanding progress on both of these metrics. We've set the course for achieving the rule of 40 as we exit 2024 with double-digit ACV growth and robust free cash flow.

Operator, please open the call for questions.

It would be great to hear on what you are seeing out there in the macro landscape. It sounds like it's still a pretty challenging environment, but pretty good results here on the ACV. So, maybe just if we could get an update on how things are trending and how you're thinking about the macro setup for 2024.

I think it's a challenging environment. There's a lot of uncertainty out there. But we're seeing great receptivity to our approach to the use of AI and how we're looking to weave it into our product lines. I think we have a unique architecture that fits beautifully with how we incorporate the Gen AI, which is at the heart of our models and architecture. As clients see that, we're seeing a lot of enthusiasm. In reality, all this is very new. People are trying to understand what it means for them. There's so much hype around this, and I think customers are appropriately a little skeptical. We actually welcome that because we think that by exploring what's really there, they'll be able to tell the difference between what will leave them disappointed and what we think we can deliver. The level of enthusiasm for not just what we're talking about, but how we're doing it, is very high.

I'll add one other perspective on that, Steve. Given the ongoing conflicts globally, inflation rates are fluctuating, our clients have been pretty resilient. Their buying patterns and investment in technology have actually stayed strong. Although we are still watching the macro backdrop, it's been pretty resilient in 2023 and into 2024. We are optimistic about the economic landscape going forward, but there are a lot of risks we need to monitor.

Alan, you were talking quite a bit about Gen AI and how clients are thinking about it. How do you cut through the noise to position Pega as a go-to solution for implementing Gen AI? For Ken, how are you thinking about modeling adoption throughout the year and its impact on the model?

We are not just positioning, but implementing Gen AI as core to our product lineup. This isn't some standalone SKU that's off to the side. It will empower our entire product line and the way our customers work. If you check out Pega's generative AI demo on our website or the Blueprint announced recently, you can see our clients realize this allows them to rethink their business in an organized, structured, and extensible way. The response we've been receiving has been brilliant, and we're feeling good about it.

Your next question comes from the line of Rishi Jaluria with RBC Capital Markets.

I wanted to stick first on the topic of generative AI. Ken, I remember at the Analyst Day last year, you talked a lot about how this is going to manifest itself in driving consumption rather than distributing pricing for a distinct SKU. Can you help us understand adoption rates of your Gen AI capabilities today and how that growth may trend in the next one to three years?

You're correct. We strongly believe that the primary value of Gen AI, particularly with tools like Blueprint, lies in reducing the barriers for clients to leverage Pega to automate parts of their business. When you see it, you'll understand that you'll be able to picture that experience in real-time. The reduction in barriers enables us to expand use cases and speed of deployment. We're not viewing Gen AI as a separate feature but as an integral part of our offering that enhances our clients' ability to automate their processes.

We've incorporated AI at the very heart of everything we're doing. This means it'll power faster adoption and growth. The primary value will emerge from this integration rather than from individual SKUs. Our approach focuses on the substantial transformative impact it can have on our entire business.

Your next question comes from the line of Jake Roberge with William Blair.

Ken, if you'd take a step back and look at the model and how that's shaping up, do you think this is the last year we will see the gap between revenue and ACV growth start to converge?

Certainly, the variances will continue to shrink. We're expecting to see over 50% of our ACV in Pega Cloud, but we still have a significant percentage that's not. As that percentage decreases, the risk of variability also diminishes. By 2025 and beyond, the difference between our operating margin and free cash flow should be much more aligned as term license revenue declines. We're making substantial progress in that direction.

If not for some accounting requirements that impact how we present revenue, we believe our metrics would be much more consistent. However, looking at a longer term should show us improving alignment as well.

I want to clarify that, while free cash flow will provide a normalized perspective of our business, there can be variability in revenue and EPS due to increased Pega Cloud opportunities, which may lead to a spreading of revenue recognition over more numerous, shorter-term contracts.

Your next question comes from the line of Kevin Kumar with Goldman Sachs.

I wanted to ask about investment priorities for the year. There was a notable uptick in free cash flow, so, Ken, can you talk about where you're seeing opportunities for leverage?

In 2024, we're still expecting operational leverage across the board. You're going to see gross margins expand alongside reduced expenses in sales and marketing as well as R&D and G&A. Our go-to-market transformation, with its focus on our clients, is key, and we'll be strategically deciding how to introduce new logos and expand thoughtfully. We're prioritizing investments in Gen AI and the synergy between it and our platform is enormous.

Ken, one quick one for you. You talked about shorter contract durations. Can you help me understand what's changed to lead customers toward these shorter contracts?

As clients explore leveraging Pega usage, the commitment periods tend to be shorter, whether that's two or three years. This shift connects to larger clients enjoying the nature of consumptive growth, leading to shorter terms but increased adoption opportunities.

It sounds like there's a lot happening with generative AI. How is Blueprint helping you win more customers and stay competitive?

The reactions we've had from C-suite executives during demos have been stunning. Blueprint allows businesses to take their ideas and instantly visualize what needs to be built, from workflows to data handling. In a few minutes, you create something that historically took weeks, transforming everything. This is brand new and evolving, and we aim for PegaWorld to showcase this fully for everyone.

Does it feel that this is becoming a more strategic conversation for Pega with both existing and new logos?

Yes, we've shifted our conversations with long-standing clients to a more strategic level. Historically, they viewed us as a solution to specific problems. Now they see us as integral to their overall operations, a gratifying shift as part of our new strategy. When we leverage our Gen AI capability, the historical barriers will look completely different this year.

I want to ask about Gen AI and how it plays into Pega's product roadmap, especially regarding autonomous agents.

We recently introduced the concept of the autonomous enterprise, which goes beyond individual agents and structures the entire organization around work, enabling automation while allowing for manual intervention when needed. This approach integrates with additional workflows and call center enhancements. We have exciting implementations of voice AI that auto-fill fields during client conversations, enhancing efficiency.

How are you viewing your consulting and channel partners' roles moving forward?

Our success relies on making everyone more knowledgeable. The integration of Gen AI will not diminish partners' roles; instead, it will empower them. Kerim has recently engaged extensively with partners to give them a head start on our Blueprint. Our partners will benefit from creating their own blueprints based on their areas of expertise, bringing added value in consultation.

Alan, can you provide an update on Launchpad, particularly the early adopter program?

I'm very excited about Launchpad. We had our initial clients go live in Q4, and the interest is promising. We're partnering with our clients to help them capture unique practices they can bring to market. Expect more updates as we progress through the year, particularly at PegaWorld.

Could you offer an update on Pega's view regarding its debt, including potential retirement or refinancing given the interest rate environment?

With our cash on hand and projected free cash flow for 2024, we'll be in a net positive cash position soon. By the first quarter of 2025, we will have more than enough cash to retire our convertible debt if we choose to do so. We are evaluating our capital allocation in this capacity as we progress.

There are no further questions at this time. I will now turn the call back over to Alan Trefler, Founder and CEO of Pegasystems for closing remarks.

Thank you very much to everyone who joined the call, especially those who got up early on the West Coast. We appreciate that. We want you to know that we're excited about where we are. The team is working extremely hard. I think everyone should come to PegaWorld because what you see there will be eye-opening. Thank you again, and I look forward to speaking with you next quarter.

This concludes today's call. You may now disconnect.