Pegasystems Inc (PEGA) 2004 Q3 法說會逐字稿

Good morning.

My name is Barney and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the third quarter earnings conference call. (OPERATOR INSTRUCTIONS).

Ms. Lewis, you may begin your conference.

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 implementation 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 market, 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 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 matter contained in such statements will be achieved.

The forward-looking statements we make on today's call are based on our beliefs and expectations as of today, October 29 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?

As you saw in our press release, Pegasystems earned revenues of $21.5 million for the quarter, impacted primarily by the delay of 2 above-average sized deals.

Those deals have since closed.

We continue to have a very strong reception for our products and continue to see more demand for our rules-based business process management software, including additional uses across more verticals.

Let me talk first about what happened in the third quarter.

We had two targeted deals, which we had expected to close.

The calendar page turned before we were able to obtain final signatures.

They have since closed and both were significant license revenue events.

As we stated previously, we will continue to see fluctuations, both up and down in our quarterly revenue, primarily due to the fact that our business is characterized by a small number of large transactions.

Our license revenue performance was also negatively impacted by the anticipated reduction of FDR revenue.

We are taking steps to better manage our closing process.

We have assigned executive closers to each and every one of our targeted deals.

That means that I have responsibility for specific customers, Alan has responsibility for some, and so on for other members of our executive team.

We have built a monthly calendar to help deals close throughout the quarter and we are focusing all of our functional resources on our sales effort in the fourth quarter.

As we sell to a broader, more diverse group of customers, substantially all of our new business employs a perpetual license model.

So as we have stated previously, we will continue to see fluctuations up and down in our quarterly revenue as we move towards this model, primarily due to the fact that our business is characterized by a small number of large transactions.

To help understand how our new business is taking hold, year-to-date revenue growth, ex-FDR, is 7 percent.

More importantly, when you look at our new business model of perpetual license revenue, the New Pega, which is selling smart business process management to a broad array of users for a broad array of uses -- that perpetual and subscription revenue represents almost 60 percent of our total year-to-date license revenue, up from 44 percent last year.

Exclusive of $10.6 million FDR arrangements, we grew our year-to-year perpetual license revenue business 77 percent.

In concert with this move to perpetual licenses, we are also continuing to implement our business strategy to partner with systems integrators in order to leverage sales and implementation of our smart BPM platform.

SI partners not only represent almost all of our platform deals, but also continue to invest in training significant numbers of their consultants on our technology to implement a growing number of deals.

This reliance on partners to implement our licenses is a positive thing.

On the other hand, it may lead to continued fluctuations on our quarterly revenue.

Our entry into new markets is happening rapidly as we move beyond specific applications in financial services and healthcare.

Year-to-date, for example, inclusive of the 2 deals I referenced earlier, we have signed 19 new clients and expanded 5 relationships.

Those 24 deals, and that compares to only 13 deals for the full-year 2003, include 18 of our Smart Business Process Management platform PegaRULES Process Commander and 6 sales of Pega built application.

To add some further color, a third of these deals were in our traditional financial and healthcare verticals, another third were sales into the insurance vertical, and the remaining were sales to other verticals such as travel, semiconductor, and manufacturing industries.

Let me walk you through a couple of examples from the third quarter.

A leading hotel and leisure company will be using our platform to optimize reservations and pricing.

This deal is significant because it has once again proved we have the best rules engine on the market.

The second example is at Nordea, the leading Nordic financial services group, who is using a Pegasystems developed application Smart Investigate built on our smart BPM platform to automate the knarly problem of payments exceptions processing.

This is exactly the kind of complex changing process, at which we excel, and in fact, Nordea was impressed not only with the business case for Pega, but also by our successful implementations at UBS and Rabobank.

I mentioned that our partners continued to invest in training significant numbers of their consultants on Pegasystems' products.

In the third quarter, for example, we trained 33 percent more customers and 55 percent more partners than in Q2.

And on a year-to-date basis, we trained 212 percent more customers and partners this quarter.

And for those of you who missed the release, we are now offering a certification course for PegaRULES Process Commander.

Again, putting the resources into training, which in turn enables our partners to learn and leverage our business.

We are focused on doing the right things for our long-term business.

Over the last several months, we have tremendously strengthened our management ranks including hiring 2 VPs for our financial services and BPM business units, all complementing our existing talents.

We have top level David Ortiz, Manny Ramirez type talents.

We have the smartest technology folks and the smartest business leaders.

We are very confident and continue to invest in the business, more specifically, in sales and marketing.

Before turning over to Chris, let me say that we're a company with excellent talent.

We've a suite of best-in-class business process management products, a platform applicable to all industries interested in managing complex changing processes, and we have Pega developed applications for those interested in capitalizing on our financial services and healthcare expertise.

With that, let me turn the call over to Chris Sullivan for a more detailed review of the financials.

Thank you Henry.

Total revenue for the quarter was $21.5 million compared to $25.1 million in the same period a year-ago, a decrease of 14 percent from the third quarter of 2003.

This decrease is due to lower perpetual license revenue, inclusive of an anticipated $3.5 million decline in license revenue associated with our restructured First Data Resources agreement.

That was partially offset by strong growth in services revenue.

On a year-to-date basis, total revenue grew 7 percent excluding the anticipated $10.6 million decline in revenue associated with the restructured FDR agreement.

License revenue for the third quarter was 32 percent of total revenue, while services revenue comprised 68 percent of total revenue.

We do not believe this reflects a permanent shift in favor of services.

Our timeless model still assumes license revenues will be 55 to 60 percent of total revenues.

Profit before taxes, decreased to $1.1 million in the third quarter of '04 from $5.2 million in the third quarter of '03, primarily due to a decline in license revenue and a planned investment in sales.

We generated $0.6 million in cash from operations during the third quarter of 2004 and ended the quarter with $95.8 million of cash and short-term securities investments.

License revenue decreased to $6.9 million from $13.6 million for the Q3, 2003 quarter, primarily due to a $7.3 million decrease in perpetual and subscription license revenue, inclusive of the anticipated $3.5 million decline in FDR revenue.

Half of our license revenue in the third quarter of 2004 is attributable to our PegaRULES technology.

As sales of the more packaged PRPC products continue to grow, we anticipate the amount of revenue recognized at time of license sale will also continue to increase.

Services revenue increased $3.1 million or 27 percent compared to the third quarter of '03.

This was driven by 21 percent growth in consulting services related to license implementations and 45 percent growth in maintenance support due to a larger installed base of software and improved pricing.

To amplify the earlier point on implementation services, services revenue grew, in part, due to new license sales in the first 3 quarters of 2004.

Of the $70.2 million in total revenue for the first 3 quarters of 2004, $21.9 million or 31 percent was from implementation services and licenses related to new customers.

As we continue to involve our systems integration partners in an increasing percentage of our new license implementations, we expect the rate of growth in implementation services revenue to decline.

We ended the quarter with a strong balance sheet, including $95.8 million in cash and investments and no debt.

In addition, we ended the third quarter with $74.5 million in combined short and long-term license installments receivable.

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

Our average deal size over the past 8 quarters has ranged from $500,000 to $1.9 million of license revenue.

The small number of license deals each quarter can cause fluctuations in the average deal value in a quarter.

Our average deal size for the third quarter was just over $0.5 million of license revenue.

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

As revenue for PegaRULES and Process Commander becomes a larger percentage of total license revenue, we expect the average deal size to be in the low end of our historical range.

International revenues have historically been in the range of 15 to 25 percent of the Company's total revenue.

In the first 3 quarters of '04, international revenue represented 33 percent of total revenue.

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

Our international revenue may fluctuate in the future, because such revenue is generally dependent up on the 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 $15 million from $17.6 million in Q3, 2003.

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

Service gross margin for the third quarter was $8.2 million or 56 percent for the third quarter of 2004.

This represents a significant improvement compared to the gross margin of $4.1 million or 36 percent for the third quarter of 2003.

This improvement was driven by a $3.1 million increase in service revenues associated with the completion of license implementation projects, higher maintenance revenues, improved utilization, and by a decrease in cost of services versus Q3, 2003.

The services gross margin rate of 56 percent is slightly higher than our timeless model would indicate.

For the first 3 quarters of 2004, service gross margin has increased $12.7 million, compared to the first 3 quarters of 2003.

R&D spending was down $200,000 versus Q3, FY03.

However, R&D spending as a percent of revenue increased to 24 percent in the third quarter versus 21 percent in the third quarter a year ago.

The year-over-year decrease in R&D spending is primarily due to reduced use of contractors.

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

Selling and marketing expenses, as a percent of revenue, increased to 34 percent in Q3, 2004 versus 24 percent in Q3, 2003.

The $1.3 million year-over-year increase in spending is primarily due to the hiring of additional sales personnel and increased sales commissions associated with higher new license bookings.

For the balance of 2004, we expect to continue this higher level of spending in sales.

G&A expenses were up 200,000 versus Q3 of '03, primarily due to governance costs related to compliance.

G&A expenses, as a percentage of revenue, was 14 percent of revenue for Q3, 2004 versus 11 percent in Q3, 2003.

This increase in percentage of revenue was primarily driven by lower revenues in the quarter.

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

Profit before tax was $1.1 million in Q3 '04, a $4.1 million decrease from Q3 of '03.

This decrease was driven by lower license revenue and higher selling expenses, offset by a $4.1 million improvement in services gross margin.

Provision for income tax was $400,000 for the third quarter of 2004.

Our effective tax rate increased slightly from 34 percent in the third quarter of '03 to 35 percent in the third quarter of '04.

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

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

Accounts receivable days billed outstanding as of September 30, 2004 was 49 days.

This is up from the previous quarter due to the consulting services revenue content, which tends to have higher days billed outstanding than license revenue.

Deferred revenue at September 30, 2004, primarily unearned maintenance fees and the billed fees from our arrangements for which acceptance for the software license or service milestone had not occurred, decreased to $9.4 million from $14.2 million 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 three quarters of '04.

This is partially offset by an increase in advanced payment of maintenance fees.

Pegasystems has experienced lengthening customer negotiations and delays in customer contract signings.

Bearing this in mind, we now expect full year 2004 revenue to be in the range of $95 to $103 million.

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 have continued to invest in incremental sales and marketing spending to support growth opportunities in the future.

We expect profit before tax in 2004 to be in the range of $11 to $17 million, depending primarily on the revenue achieved, and positive cash flow from operations in the range of $7 to $11 million.

As a reminder, our tax rate is expected to be between 35 and 40 percent in 2004 compared to an overall rate of 19 percent in '03.

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.

Thank you Chris.

We are confident about our prospects and we continue to invest in our leading edge software.

Our goal is to own the market for automating complex, changing business rules.

Next week, we will be announcing a significant set of upgrades to our Smart BPM platform including even more brainpower.

A holistic platform that provides business activity monitoring, analysis and optimization tools, developer tools like next generation decision trees and process swim lanes, .powerful case management capabilities to manage real work business processes across enterprises, enhanced automation with new levels of portal integration and enterprise integration.

We’ve always built to open industry standards.

We've always built our platform to accommodate change, and our new version has been more change- aware because it can run what if scenarios, easily simulate new business processes before they go live.

And we have taken the concept of insanely open to new levels with enhanced standards and J2EE support.

What this means in practice can be seen from some recent interactions we've had with customers and prospects.

I recently spent 4 days at SIBOS, the leading international financial services conference, where 6,000 participants from financial services organizations from around the world came together to help plan and direct the industry's future.

We had a chance to work with customers and others like RBS NatWest, Caylon Credit Lyonnaise, Halifax Bank of Scotland, JP Morgan Chase, Citigroup, Lloyds, National Australia Bank, Nordea and United Overseas Bank joined us and IBM, to really understand what we could be doing together in the future to hear how Pega's combination of brainpower and automation can tackle real problems they have.

Pegasystems is widely acknowledged as the leader in managing the tough stuff, problems like complex billing or missing wire transfers or detailed risk and compliance controls.

There were articles written about our ability to automate the audit trail and our success in managing exceptional circumstances, an article that quoted IBM on the advantages of using Pega’s hub to allow customers breakthrough value, providing not only reduced costs and risks, but also greatly improved customer service.

Pega was on the dais in a session about emerging standards in the financial services via transfer business and we are a key participant in where the industry is going in these areas.

In addition, we see an increasing and broadening interest in managing business rules and business processes across this industry as well as several of the others in which we have been doing increased work.

That's why when Wells Fargo wants a leading-edge compliance program and platform to ensure the integrity of their investment, they select Pegasystems.

Alternatives, in, for example, Enterprise Content Management, cannot actively manage the complexity around setting, managing and updating thresholds, and directing different review levels, as well as, not having the sort of one and done active reporting and analysis that a RULES and BPM engine working together can provide.

And that's why when the hotel and leisure industry has a leading company that wants on-the-fly decisioning unified with on-the-fly implementation, they select Pegasystems over ILOG or Blaze to get that level of power and agility.

And that's why our credit card applications and other financial services organization applications built on our leading-edge BPM platform continue to be utilized and bought by leading organizations.

They understand the power, the control we offer and therefore the cost management and service enhancement and agility that they offer to the operations and their customers.

Pega's on-the-fly decisioning, process stimulations and ability to impact business in real life fashions, allows organizations to get unprecedented control and power.

That's why we are confident of our long-term prospects.

And this is why Pegasystems' Board of Directors has authorized the repurchase of up to $10 million worth of Pegasystems common stock.

At the Company's discretion, the purchases can be made from time to time in the open market or in privately negotiated transactions.

Under the program, shares may be repurchased in such amounts as market conditions warrant, subject to regulatory and other considerations.

Management believes the long-term prospects for our best-in-class Business Process Management software are very strong and the stock repurchase program enables the Company to utilize its strong cash position in a manner that benefits both the Company and its share holders by enhancing earnings per share and return on equity.

And with that, let me turn it over to the operator for any questions.

(OPERATOR INSTRUCTIONS) Richard Davis, Needham & Company.

Just checking the math on the numbers, but by my math, year-over-year license revenues, excluding First Data, March quarter was down 24 percent, June quarter was down 6,and the third quarter was down 32 percent.

You have increased marketing spending since March.

I guess, what would be useful -- it seems like the payoff so far has been in services growth.

Could you talk about when we might see some manifestations, if this spending is going to pay off in software growth?

Hi, this is Henry.

Thanks for the question, Rich.

The implementation services are quite up as a precursor to licensee growth.

And if you do the math in terms of the guidance for the year, I think, you will see some of those results we expect, will show up in the fourth quarter.

Do you have a sense of how 2005 looks like it might play out?

I think it is very premature to talk about 2005 at this time.

Philip Rueppel, America's Growth Capital

The two deals, large deals that slipped, were they direct sales deals or were they deals that were influenced by some of your partners?

Let's see.

They were both direct sale deals.

One of them was highly influenced by a partner.

But, we sold directly to the end user.

I guess though the -- the underlying part of the question is, and you mentioned it a little bit in the conference call was, as you have more partners, does this necessarily mean that visibility into kind of closure rates gets a lot more fuzzy going forward or have been able to put processes in place to effectively monitor and send partners to get deals closed by their projected -- in their projected time frame?

Phil, this is Chris.

With the partners, the involvement with the partners in the implementation as opposed to the selling will, to some degree, cause some fuzziness in our visibility.

When we are in control of the service implementation, we have better, greater visibility to when the milestones will be completed.

We work very closely in our processes around certification and other things with partners, are the way that we will influence and manage to keep that process in control.

But, the fact of the matter is, as you allow and encourage the partners to work with us in the implementation services, the control of that project is lot more largely in their hands than ours.

But again, our strategy is to have partners more involved with building certification and training so that the confidence of those folks is comparable or exceeds ours over time, and we are looking for customers to welcome that partner involvement.

But it does have some impact on the visibility to exactly when the projects will be completed.

We can have greater influence sometimes on the resource deployment when we have the full control of the project.

Phil, it's pretty clear that the partner program is bearing fruit.

We are seeing significant deals that we would simply not have ever been a participant in, had we not made the partner outreach, and I think a lot of Henry's investment in staffing up the sales and marketing function has been to make it so we can respond to that sort of leverage to be in more pieces of the business.

Ultimately, we think that the partner approach is very much around getting leverage, and you might just see us happy with some of our progress.

We are still early in it, working hard to continue.

Joseph Halpern, Halpern Capital

Most of my questions are kind of answered, but I’ll kind of tackle the servicing question from a different angle.

You have been doing well in that aspect of your revenues.

Traditionally, are these clients purchasing applications prior to the servicing or is this something where you are going to be working on the servicing and you recognized the revenues afterwards?

I am just trying to also figure if that -- if licenses come from that or, it is what we've seen?

This is Henry.

The services project comes in 2 major flavors.

In one case, there are implementation services associated there with the large applications deployment, and the services occur before the licenses is recognized as revenue, and it is only upon customer acceptance that the license is recognized.

It accounts for a significant chuunk of our professional services.

In the other case, we provide time and material services on a non-essential manner to where the customer themselves or a partner, the prime, if you will, in the services engagements.

And in those situations, the license is recognized at the time of delivering them.

So, in this quarter, you might have given the number, I am not sure, in the discussion, but what percent of your services were in the former, the larger applications before license is recognized?

This is Chris.

The majority of our services still relates to application work in which the acceptance or the completion of the services will be a factor in the revenue recognition.

Although we are seeing with particularly the platform sale, the PRPC platform, when we are selling that, that is something that the customer is buying and often times now, they are seeing the opportunity to either build out the application themselves or with a qualified partner.

But the majority is still of our sales through at least the third quarter of this year, tend to be service engagements around applications that we will take the revenue when the services are accepted to complete.

And then, in terms of the large European contract that you talked about in the previous quarter, and this quarter.

Was that a term license that was renewed, and was that, if it was, was that unscheduled or is it something that kind of came up a little earlier than their renewal day?

In terms of which license, were you referring to, which deal?

Yes, the large European one.

This was actually a -- it had multiple factors, but one significant factor was, it was indeed a term license renewal and it was on time more or less.

(OPERATOR INSTRUCTIONS).

Andy Schopick, Nutmeg Securities.

I would like to ask if would comment any further on the two large deals that have closed subsequent to the end of the quarter, whether you could give us the combined revenue associated with these and break it down possibly between license and services?

Are you willing to comment any further on that?

Well, let me just give you just a little bit further color on it.

Both of these deals were each well over a $1 million.

And in terms of the revenue recognition associated with having closed them, will it be fully recognized as license revenue predominantly in the fourth quarter?

The answer is, yes.

Okay.

Chris, I do want to ask you a little bit about the guidance as well.

Clearly you seem to be signaling a fairly strong fourth quarter and for purposes of convenience if we use, your revenue guidance, and say it comes up close to 100 million for the year.

It implies something close to 30 million for the quarter, which would suggest a very strong up quarter from a year ago when revenues were about 23 million, I believe.

How confident are you in your ability to close business in this timeframe to realize, say, even the middle range of your current guidance?

I don't want to necessarily pinpoint anything within the rage, the range stands on its own.

But, even the range of 25 to 32 million in the fourth quarter does imply some reasonable confidence that it would be a good quarter.

But in terms of our confidential levels, our confidence level is the same as our confidence level needs to be to provide guidance.

It's very high confidence, because that's a range we land in.

The industry has shown a little bit of schizophrenia this year.

We had a considerably weak quarter by the industry standards in the second quarter and we have mixed results in the third quarter after a pretty strong first quarter.

So, I'd need a crystal ball to say exactly how it is going to turn out for the fourth quarter, but based on our pipeline activity, the degree of completeness in the fields, in the pipeline, that range that we provided is one we have reasonably high confidence in.

Okay, let's leave it at that and let's hope for the best.

We're not just hoping for it – we're working on it.

Hal Berry , Graham Partners.

That last question was pretty much it -- but I guess, if we did do 30 million and somewhere around 15 cents, would you expect that the add to the Company's target model in terms of percentage of sales coming from license in the fourth quarter of closer to 60 percent?

And then I got a quick follow up.

The exact mix is something I wouldn't say precisely what we feel.

We do expected that if we hit the range, particularly in the mid point of the range that would be implied, a number favoring licenses.

But, the exact percentage is hard to predict.

That would be a factor of the completion of milestones and other things that we have yet to have certainty on, but some visibility too.

Okay.

The follow up being, I think it was early March that we joined the BPM group with IBM, correct?

I was just wondering if you could comment as to what sort of resources they are putting behind it and how the pipeline looks through that channel now?

We are actually quite pleased with the progress that we've made with IBM is so far.

There is a lot of activity and increasing amount of pipeline that we are jointly working on, and we are really quite pleased with the results.

They are in the process of getting ready to train a number of that people in our product line.

So all of that are indicators, which are quite positive.

Having said that, I cannot point to any deal that we have yet signed, because of the IBM relationship.

At this time, there are no further questions.

I want to take this opportunity to voice my enthusiasm for our product, partners, and people.

We are enthusiastic not only about 2004, we have a strong pipeline and are working diligently to move prospects through it, so that they can start reaping the benefits of our best-in-class technology, and we are also excited about 2005.

Come see us at AEA, the second week of November and/or the Needham Conference in January.

Thank you operator, that concludes our remarks.

This concludes today's conference call.

You may now disconnect.