Pegasystems Inc (PEGA) 2004 Q2 法說會逐字稿

Good morning.

My name is Tamara, and I will be your conference facilitator.

At this time, I would like to welcome everyone to the second quarter 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 period.

If you would like to ask a question during this time, simply press star, then the number 1 on your telephone keypad.

If you would like to withdraw your question, press star, then the number 2 on your telephone keypad.

Thank you.

Ms. Lewis, you may begin your conference.

Thank you, Operator.

Before we begin, I would like to read our Safe Harbor statement.

Certain statements contained in this conference call may be considered forward-looking as defined in the Private Securities Litigation Reform Act of 1995.

These statements involve various risks and uncertainties that could cause the Company's actual results to differ from those expressed in such forward-looking statements.

These risks and uncertainties include the impact of the volatility of our quarterly operating results, difficulty in predicting the completion of product implementations and consequently the timing of our license revenue recognition, the timing of term software license renewal, customer acceptance of our new PegaRULES process commander technology, our ability to develop new products and evolve existing products, interest rates, market trends, the impact on our business of the ongoing consolidation in the financial services and healthcare markets, our ability to attract and retain key employees, reliance on certain key third-party relationships, management of the company’s growth, and other risks and uncertainties.

Further information regarding these and other factors which could cause the Company's actual results to differ materially from any forward-looking statements contained in this conference call is contained in the Company's most 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.

The forward-looking statements made on today's call are based on our beliefs and expectations as of today, July 29, 2004, only.

We do not undertake any obligation to revise or update publicly any forward-looking statements expressed in today's conference call.

With us today we have Alan Trefler, chairman and CEO;

Chris Sullivan, chief financial officer; and Henry Ancona, president and COO.

Henry, would you like to begin?

Thank you, Beth.

Good morning, everyone.

As you saw in our press release, Pegasystems delivered solid performance for the second quarter.

We earned revenues of $24m and pretax profits of $3.3m.

Last year our Q2 total revenues were $25.5m.

So excluding the known $3.5m reduction in First Data resources revenue, we achieved 10% revenue growth.

Additionally, perpetual and subscription license revenue grew $1.5m, or 33% versus a year ago, which is strong proof of our success with new license sales.

We are also continuing to see strength in our services revenue, another indicator of new license sales.

Both implementation and maintenance revenues are up based on increased license sales and a larger installed base.

This quarter, as with last, much of that growth was based on PegaRULES Process Commander, a BPM platform first introduced only 18 months ago but already gaining significant traction.

We continue to penetrate new industries and, equally important, continue to see purchases based on new uses.

During the second quarter, for example, a leading chip manufacturer bought our sophisticated BPM platform for use establishing an overseas fab.

This is great news for us and for them.

They will be using PRPC in support of a fully automated factory systems environment, writing and storing manufacturing specs, integrate specs with setup and configuration approval workflow, and automate setup and configuration rollout.

PRPC was also bought by RS Medical in support of a billing and scheduling application for 300 users coordinating services among 400,000 patients and 5,000 medical professionals, and we had success with existing customers dipping into the PRPC waters -- a very important component of our growth strategy.

A long-time user of our Exceptions Management application, this quarter bought PRPC for use in event-driven marketing.

That said, this was a frustrating quarter in terms of closing deals.

The software industry, as a whole, has seen extended sales cycles, and we were not immune to this.

We are continuing to invest and to improve our sales process.

By way of reminder, we reorganized our sales team earlier this year from a transaction selling model, selling one customer one product and moving on to the next, to a relationship model, working with a customer as a long-term partner to jointly build our futures.

Our PRPC platform lends itself to this as it can be used throughout the enterprise in the broad range of applications, as I mentioned earlier.

And this is now starting to pay off.

I gave you the example above of a long-time user having just bought PRPC for that first use.

I'll also quote now from one of our customers -- "Working with Pegasystems I feel I have a real partner."

We're doing a lot of things to support our sales force.

For example, we are rolling out a suite of training programs for our PRPC product.

When people get their hands on this product and see how easy it is to use, how well it can accommodate complex decisions and implement real work, it's infectious.

So we want to get this BPM platform into as many hands as possible.

We have made a commitment to training, and in the first half of 2004, we trained more people than we did all of last year.

We trained 126 customers in the second quarter alone, and we just introduced a Pega PRPC boot camp -- five 10-hour days -- and we sold out every session.

Our partnership program continues to develop.

We announced this morning a strategic partnership with IBM's global banking group.

This is the highest level of partnership at IBM.

Pega is now only one of a handful of partners at that level with a global banking group.

Pegasystems and IBM are partnering in the payments and risk and compliance markets, where a smart BPM technology and application bring much value.

The agreement covers North America, Europe, and countries in Asia Pacific.

The agreement, while non-exclusive, is expected to bring us into many new opportunities in the coming months.

We are also broadening our partnership with Oracle by including Pegasystems as a key component of Oracle's Check 21 solution set.

We were one of only six partners invited to participate in their 2004 sales kickoff in Las Vegas.

With our other key partners -- with Accenture, Bearing Point, CSC, Cognizant, and Satyam, we are continuing account planning and development with solution opportunities in existing and prospective clients.

And we're doing all of this, focusing on our customers, our products, our partners, and our sales team while continuing to improve our operational efficiencies.

Chris will provide more detail but take a look at the services line where both revenue and margin continue to improve year-over-year.

We have growth in implementation revenue as we sell more new license; we have growth in training revenue as we grow demand for our training courses; and we have growth in maintenance revenue based not only on the larger installed base but also on improved pricing.

We continue to demonstrate our ability to develop and deliver smart BPM applications for a broad range of requirements existing uses for our traditional industries and new uses, both within our traditional verticals and extending into new industries.

We will continue to deliver competitive new BPM products throughout this year that meet and exceed customer's needs.

With that, I'll turn the call over to Chris Sullivan for a review of the financials.

Thank you, Henry.

As Henry indicated, our performance in the second quarter of 2004 was solid.

Total revenue for the quarter was $24m compared to $25.5m, or a decrease of 6% over the second quarter of 2003, despite the $3.5m year-over-year decline in revenue associated with the First Data resources agreement.

Our mix of license and service revenue improved versus the first quarter of 2004, however, the mix was below our timeless model of approximately 60% license.

This was due to the decline in the FDR license revenue, fewer scheduled term license renewals, and continued growth in the services revenue.

Profit before taxes decreased to $3.3m in the second quarter of 2004 from $5.9m in the second quarter of 2003 primarily due to a decline in revenue and a planned investment in sales.

We generated $2.4m in cash from operations during the second quarter of 2004, and ended the quarter with $95.2m of cash and short-term securities investments.

License revenue decreased to $11.7m from $15.9m for the second quarter of 2003 primarily due to the anticipated decline in FDR revenue and lower term license renewals, extensions, and additions with existing customers.

Perpetual and subscription licenses grew 33% over the same period a year ago.

Services revenue increased $2.8m, or 29% compared to the second quarter of 2003.

This was driven by 20% growth in our consulting services related to license implementations and a 50% growth in maintenance support due to the larger installed base of software and improved pricing.

Almost half of our license revenue in the second quarter of 2004 is attributable to our new PegaRULES technology.

To amplify the earlier point on implementation services, services revenue grew, in part, due to new license sales.

Of the $48.7m in total revenue for the first half of 2004, $17.1m, or 35% of that, was from implementation services and licenses related to new customers.

We ended the quarter with a strong balance sheet including the $95.2m in cash and investments and no debt.

In addition, we ended the first quarter with $77.9m in combined short- and long-term license installment receivables.

As a reminder, these receivables are related to unbilled and term licenses and are indicative of future payments.

Our average deal size over the past eight quarters has ranged from half a million dollars to $1.9m of licensed revenue.

The small number of license deals causes fluctuations in the average deal value in a quarter.

Our average deal size for the second quarter was just under $700,000 of license revenue.

This is reflective of the smaller average deal size associated with implementations of PegaRULES and Process Commander.

International revenues have historically been in the range of 15% to 25% of our total revenue.

In Q2 2004, international revenue represented 43% of our total revenue.

This spike was driven by one very large European customer who renewed its license with us and also would like to purchase additional new software.

Our international revenue may fluctuate in the future because such revenue is generally dependent upon a small number of license transactions during any given period.

Our recent SEC filings include more information on the composition of our revenues.

For the quarter, gross profit decreased to $17.9m from $18.9m in Q2 2003.

This year-over-year decrease was due primarily to lower license revenue partially offset by significantly improved service gross margins.

Service gross margin was $6.3m or 51% for the second quarter of 2004.

This represents a significant improvement compared to the gross margin of $3m, or 32% for the second quarter of 2003.

This improvement was driven by a $2.8m increase in service revenue, improved utilization, and a modest decrease in cost of services versus Q2 of 2003.

For the first half of 2004, service gross margin has increased $8.6m compared to the first half of 2003.

R&D spending as a percent of revenue decreased to 20% in Q2 2004 versus 21% in Q2 2003.

R&D expense in the second quarter of 2004 was approximately $600,000 lower than last quarter and the second quarter of last year when investments were higher due to impending releases of new products.

The decrease is primarily due to the reduced use of contractors.

We expect to competitively invest in R&D, though our spending levels will occasionally increase or decrease depending upon new products development schedules.

Selling and marketing expenses as a percent of revenue increased to 33% in the second quarter of 2004 versus 25% in the second quarter of 2003.

The increase is primarily due to the hiring of additional sales personnel and increased sales commissions associated with higher new license bookings.

For 2004, we expect to continue the higher level of spending.

This higher level of spending is consistent with our timeless model.

G&A expense as a percent of revenue was 11% of revenue for Q2 2004 and Q2 2003.

Our timeless model for G&A expenses is 10%.

Profit before tax was $3.3m in Q2 2004, a $2.6m decrease from Q2 2003.

This decrease was driven by lower license revenue and higher selling expenses offset by a $3.3m improvement in our service gross profit.

The provision for income tax was $1.2m for the second quarter of 2004.

Our effective tax rate increased slightly from 34% in the second quarter of 2003 to 35% in the second quarter of 2004.

We expect our tax rate to approximate the statutory rate somewhere between 35% and 40% for future periods.

Because the tax rate for 2004 is expected to be substantially higher than it was for the full year 2003, we are focusing on profit before tax as an indicator of 2004 business performance.

Accounts receivable days billed outstanding as of June 30, 2004, was 39 days.

Deferred revenue at June 30, 2004, primarily new client license and/or unearned service or maintenance fees decreased to $13.2m from $14.2m as of December 31, 2003.

The decrease is primarily due to the recognition of revenue on the completion of several large projects in the first half of 2004, and that was partially offset by an increase in advance payments of maintenance fees.

As Henry has said, the software industry, as a whole, has seen lengthening negotiations cycles and delays in customer signings.

We are not immune to these trends.

Bearing this in mind, we now expect full-year 2004 revenue to be in the range of $95m to $106m.

This revenue expectation is based on our expectation of continued new business success tempered by fewer scheduled term license customer renewals, and the anticipated further decline in FDR license revenue versus a year ago.

We are continuing to invest in incremental sales and marketing spending to support growth opportunities of the future.

We expect profit before tax in 2004 to be in the range of $12m to $20m depending primarily on revenue achieved and a positive cash flow from operations in the range of $10m to $16m.

As a reminder, our tax rate is expected to be between 35% and 40% in 2004 compared to an overall rate of 19% in 2003.

This is contributing to an expected EPS decline on a year-over-year basis.

That concludes our financial summary, and I'll turn the floor over to Alan.

Thanks, Chris.

As everybody knows, it's been a tough market out there, and the enterprise software business is always choppy and volatile.

But we're a scrappy and battle-tested company including in tough times, and we've shown we can add value, tangible ROI and real value to customers and generate cash even in difficult circumstances.

I'd like to look back over this sort of last tough period to the whole year -- to go back to last summer at this time when we had just begun a more aggressive rollout of our PRPC technology, our PegaRULES Process Commander, fourth generation platform.

Introducing for customers the idea of managing decisions and processes the way that data is managed; in a way that organizes it, can centralize it, makes it reusable and yet allows business users unprecedented access to specialize things to meet their needs.

PRPC does this by automating processes, by being built around a brain, being built on a world-class rule engine, being built for change and being built in a way that is insanely open, that is standards based and can weave itself into a customer's existing systems and run across a customer's platforms.

That, in turn, means that they can get return on their investment today, a return on their investment tomorrow, and we're seeing an increasing interest into the way the architecture gives our customers a future-proof approach to technology; where they can know that the system, still in its very, very early stages of its lifecycle, will be able to grow and evolve with them, making us have the chance to be a franchise inside those customers' organizations as they increasingly find additional ways to roll it out.

And our customers are starting to talk.

We're seeing increased interest in the way that our software supports their on-demand approach, where they want to be able to apply new rules, apply new business processes to new uses; to be able to broaden and deepen the way that they take the intelligence that drives their business and leverage it through the power of automation, through the power of processes, through the power of rules.

We are seeing that customers are finding ways to roll this out across their businesses, and we think that's very exciting and indicative of the important decisions we made years ago when we began the significant investment in this generation of the technology -- technology that can help in departments and can drive value across enterprises.

The good news is our partners are starting to see the potential of this, and we are having increased traction with partners -- much more than I can remember at any time in Pegasystems history.

Just in the last couple of months, I was a keynote at the CSC Health Care Conference.

We spoke on stage with Charles Phillips at Oracle's ISV event, and comparably to how we've been treated by CSC,Oracle and now IBM have decided to feature us in press releases that they put out.

Never before have we seen this level of engagement, and we're quite excited by it.

We think it is a very, very positive sign that our strategy of deepening our involvement and our work with partners is actually beginning to get traction.

At our BAI conference, the Bank Administration Institute conference in May, a leading banking event, we participated as a IBM partner and prior to the conference we presented at their check-imaging forum.

So we're seeing a lot of energy, and we're seeing a lot of opportunity.

I'm especially pleased that just this morning, IBM announced, and we announced as well, a partnership that I think has the potential to be very, very important for us.

A deepening of our historical strength in banking that shows that IBM, looking objectively at what we can do, selected us because we are excellent in managing exceptions, we're terrific at applying ROI, at leveraging the IBM product stack, and that we've got a wonderful opportunity to do things that will qualify us for excellent customer references, strong customer results, and leveraging the way that customers want to apply technology in an on-demand world.

It's a pretty good complement for the way IBM is positioning itself, and we're very excited.

So let me briefly wrap up by saying what I think the recent technology trends mean for the industry and for Pega.

We are seeing an increased acceptance and interest in the way that process management and rules come together.

We're seeing an increased breadth of opportunity, and we're seeing that people are understanding how they need to build for change our trademark phrase as a key element of a business strategy.

We are seeing that new technologies like grid computing, which are coming out, and the whole on-demand philosophy play beautifully with this build-for-change mantra, and we think that after having worked on this problem for literally about 20 years, we have unusual insights, we have patents, and we have terrific understanding of where this can go.

We were thrilled that Gartner chose to improve our position in their leader quadrant of the BPM magic quadrant, showing that we have an exceptional level of innovation and that we really have a completeness of vision in terms of how we position and think about our products.

I think it really reinforces that if the industry unfolds the way we see it, we truly will be the right company in the right market.

So, with that, let me turn the call over to questions.

But first -- Henry, would you --

Thank you very much.

I think we'll open it to questions from our audience here.

[operator instructions]

Your first question comes from Richard Davis with Needham and Company.

Thank you.

When you saw the turbulence for the June quarter with regard to what you saw was extended sales cycles, was there any commonality as to why people decided to delay purchases?

Was there any commonality with regard to industry concentration, et cetera?

Hi, this is Henry.

Frankly, we did not.

Most of the deals that we saw where the sales cycle was extended beyond where we would have preferred were lengthened for lots of different reasons.

On the other hand, the reasons, as described, are often not the real reason that's going on, which is the inability to get final approval for spending.

And so my view is that top management in several of our accounts are releasing the purse strings more slowly.

Okay, thank you.

Our next question comes from Gideon Kory with Roth Capital Partners.

Hello.

Regarding the lengthy cycles -- do you see that -- to what extent it comes in your direct sales versus your partner channel?

This is Henry.

Well, our direct sales work in conjunction with partners.

It's not really a channel in the sense of a value-added reseller might be a channel, and we've seen that equally in deals, which include a partner and in deals which do not.

So it cannot be attributed to partners coming on -- learning the product and kind of feeling more comfortable with the product?

No, not at all.

And regarding IBM relationship -- the new one that has been announced today -- how many deals in the past have been done with IBM in the banking?

I don't have the number off the top of my head, but we can probably get back to you.

Hold on, Alan might have a comment.

Well, I can give you some sort of a more subjective commentary based on the fact we've worked in conjunction with IBM for years, but we've never worked very closely with them in banking.

And, as a result of a very conscious set of decisions about two years ago, we decided we wanted to change that, and so we think that this is the next step -- certainly not the final step, but the next step in what's been a conscious strategy in which we have, for example, folks like Mark Green come and address our sales force a little while ago, and being able to really start to create visibility within our company to what IBM can do for them and also we're now actively working in conjunction with IBM to get the word out broadly to their sales force.

This is unlike anything we have done before, and we think that, coupled with the fact that we support the IBM technical stack extremely well, it should be pretty promising.

We have never before this had the occasion to have our message get out to the IBM sales force through IBM.

So, you know, the proof, of course, is in the pudding, but it's been a lot of work, a lot of energy to do this sort of deal with IBM.

This is not, to our mind or, we believe, to IBM's mind, a casual partnership at all.

We think that this is viewed is something that's going to get a lot of energy inside both companies.

Analyst And the last question about Oracle relationship that you just mentioned -- where do you see Oracle positioned in the Check 21 and what is the opportunity for you there?

We think that Oracle has an excellent position in Check 21 because the number of the databases that banks use in conjunction with Check 21 processing are Oracle-based.

But we are looking to do work with Oracle, sort of, on a broader tableau.

Oracle is talking a lot about this whole grid notion and being able to really leverage across an extended and broader enterprise, and our technologists and some of our marketing people feel there's a lot of opportunity way outside of the banking sectors and other traditional sectors.

So it was terrific to get the sort of recognition we got, and I think it's a real tribute that our partner organization is making tangible progress on getting the sort of visibility that I think is going to help a lot as the markets sort of come back, and buyers can reach deeper into their pockets again.

Thank you.

Your next question comes from Phil Rueppel with America's Growth Capital.

Great, thanks, a couple of things.

First, on sort of sales force productivity, can you talk a little bit about -- sort of, reduction or sort of the lowering of the range of guidance -- does it have anything to do with sort of the ramp of the sales force productivity and kind of the new direct sales force?

This is Henry -- no, in fact, quite the contrary.

We are really quite pleased with the productivity ramp of our new salespeople.

We've got several of our new salespeople on board just a few months finding and closing new deals.

That is not the reason that we brought our guidance down somewhat.

The reason we brought our guidance down somewhat has everything to do with the market environment that we see ourselves competing in.

Okay.

And then just to poke a little bit more about the depth of this new IBM announcement, just to get a perspective -- will it still be a sales kind of team with a Pegasystems sales rep with IBM?

Or does their sales force get quota credit?

Is it on the IBM price list?

And then, from a services perspective, do you see that IBM will be doing more of the consulting and implementation?

Or will that still have something that Pegasystems is in control of?

I think the deal -- it will vary deal-by-deal is the answer to the question.

In no situation do I expect Pega not to work closely with IBM.

This is a partnership, this is not a channel.

So in every case I expect Pega and IBM to work closely together.

And so in many situations, IBM will be the prime contractor and deliver the bulk of the services.

In many cases, I would expect them to subcontract the services to us.

And yet in other cases, we will deliver the services -- or at least some of the services -- directly to the end user.

It will be a deal-by-deal situation.

The most important factor here is that our software, as Alan has mentioned a minute ago, works beautifully on the IBM stack and not only leverages their services but also all their hardware and middleware.

Right, and it sounds like it's focused on the quality and exceptions products.

Do you see that if, you know, this is successful, could it be extended to some of your other products -- the customer process manager, for example?

I would never say never.

Okay, thanks.

Phil, this is Chris on a follow-up to your guidance question.

I wanted to just clarify in the guidance that I provided earlier in my script, I just wanted to make sure I clarify that the guidance in the press release for profit before tax is $12m to $18m.

That is the guidance range that we intended to provide.

I may have misspoken my transcript earlier, and so I just wanted to clarify $12m to $18m is our expectation for PBT.

Great, okay, thanks very much.

Your next question comes from John Maietta with Needham and Company.

Hi, thank you.

Actually, a question for Chris -- we've seen an uptick in service margins over the past couple of quarters.

How do we think about those, going forward?

Kind of a mid-40s percent range?

Is that kind of within the ballpark?

Yeah, I think the way I look at it is sort of to look at the two different elements.

Our maintenance is growing and, as a result of the growth in our perpetual license business, we are seeing that grow at a nice clip.

So our maintenance margins are improving and starting to achieve what we would view as benchmark high 70% margins.

And we think that's sustainable, going forward.

On the consulting side of the implementation services, we do believe that's a business that can and should maintain somewhere around the low to mid-30s in our gross margins, and today we're just a little bit below that.

So, if anything, we think there's a modest room for improvement in the long term, but it's largely sustainable where we are today.

Okay, great, thank you.

Your next question comes from Joe Halpern with Halpern Capital.

My question has been answered, thank you.

At this time, I'd like to remind everyone, in order to ask a question, please press star, then the number 1 on your telephone keypad.

At this time there are no further questions.

Ms. Lewis, are there any closing remarks?

Thank you very much, Operator.

Thank you all for your time.

We'll be at a number of upcoming conferences, including America's Growth Capital here in Boston next Tuesday, Halpern Capital in San Francisco the following week, and Roth Capital conference in New York the second week of September, and then back in Boston for the Cowan conference.

Please contact Beth Lewis for additional information.

Thank you, Operator, that concludes our remarks.

This concludes today's conference call.

You may now disconnect.