Pegasystems Inc (PEGA) 2007 Q3 法說會逐字稿

Good day, everyone, and welcome to Pegasystems' third-quarter 2007 earnings call. As a reminder, today's conference is being recorded. Today's speaker will be Alan Trefler, CEO and Chairman, and Craig Dynes, CFO. Mr. Dynes will now begin the call.

Good morning. Welcome to the Pegasystems 2007 Q3 earnings conference call. This morning I am in New York at the Brean Murray Technology Conference, while Pegasystems' Chairman and CEO, Alan Trefler, is in our head office in Cambridge.

Before I introduce Alan, I will start with our Safe Harbor statement and then provide my financial commentary. Certain statements contained in this presentation may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words anticipates, projects, expects, plans, intends, believes, estimates, targets, and other similar expressions identify forward-looking statements, which speak only as of the date the statement was made. Because such statements deal with future events -- Alan, I wonder if you could finish this statement. I've got to get a drink of water here.

They are subject to various risks and uncertainties. Actual results for fiscal year 2007 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 the forward-looking statement include, without limitation, variations in demand and the difficulty in predicting the completion of product acceptance, and, consequently, the timing of our license revenue recognition; the level of software renewals; our ability to develop new products and evolve existing ones; the impacts to our business of the ongoing consolidation of financial services and health care markets; our ability to attract and retain key personnel; reliance on key third-party relationships; management of the Company's growth; and other risks and uncertainties.

Such information considering factors that could cause actual results to differ materially from those projected is contained in the Company's filings with the Securities and Exchange Commission, including its report on Form 10-K for the year ended December 31, 2006. The Company undertakes no obligation to update revise or update forward-looking statements as a result of new information, since these statements may no longer be accurate or timely.

Craig, are you ready to head back?

Yes, sorry about that. I am in a hotel in New York and seem to be losing my voice, which is unfortunate because Q3 was a great quarter.

To start with, we had record revenues of $42 million, up more than $6 million, 18%, from Q2. Our year-to-date cash flow from operations is now more than $18 million and we ended the quarter with $145 million in cash. Finally, we have now been profitable in every one of the three quarters in 2007, with a net income of $3.5 million for Q3 and $5.2 million for the year to date.

Revenue was $42 million for Q3, $115 million for the first nine months. Our revenue is up 25% from Q3 2006 and up 28% for the first nine months of 2006. License revenue is powering this growth. License revenue is up more than 60% compared to the third quarter of 2006 and the first three quarters of 2006. Revenue from perpetual licenses is up $11.6 million, or 74%, for the first nine months of 2007 compared to 2006.

Our term license revenue is also up 35% for the first nine months of 2007 over the same period in 2006. Not only is term license revenue up, but we continue to build an inventory of term licenses. We now hold $33.9 million of term license arrangements will be recognized as revenue in future periods. This is an increase of $23 million from where we were at the end of Q3 2006. The details of how this inventory of term licenses will hit our P&L as revenue in future periods is provided on page 17 of the 10-Q.

Services revenue was $28.3 million in Q3, up 13%, or $3.3 million from Q3 of last year. Maintenance revenue grew 18% in Q3 to $7.8 million from $6.6 million in Q3 2006 as there was expanding number of customers who renew maintenance on an annual basis.

Q3 Gross profit was $26.3 million, up almost $8 million from Q3 2006. Professional services gross margin increased to 44% in Q3, a small increase from 43% in Q2. Year-to-date, services gross margin is 42%, two percentage points better than the first nine months of 2006. We anticipate that the strong demand for services will continue into Q4. In fact, we have a large number of projects that are scheduled to go live in Q4.

To keep up with this demand, during Q3 we increased head count in the services organization by 25 to 241 and already in Q4. We have added 36 new professional service employees. These employees will be deployed in consulting, customer support, and training roles. Our service organization is doing a great job of recruiting, hiring, and on-boarding top-quality staff.

Total operating expenses in Q3 were just over $23 million, up a little more than $1 million from Q2, a result of increases in R&D and sales and marketing, net of a reduction in G&A expenses. R&D expenses increased by about $400,000. We will continue to invest in R&D to increase our leadership position in the BPM market. We have used offshore contractors for R&D and now we are in a process of hiring our own offshore employees to supplement the contractors. We have made progress in this regard and we have already established an office and have started to hire our own offshore R&D employees. As a result, R&D costs will continue to increase.

Selling and marketing expenses were up by about $1.2 million to $12.8 million in Q3 from $11.6 million in Q2. The increase was due to an increase in head count and commission expenses associated with greater license signings in Q3. G&A expenses increased in Q3 from Q2. G&A expenses in both Q1 and Q2 were unusually high due to the costs associated our restatement.

Our quarterly tax rate in Q3 was exactly on the target of about 32%, however our numbers are still relatively small and as such, any discrete tax items can cause provision to bounce around a little from quarter-to-quarter.

We are now profitable for every quarter this year compared to losses for all three quarters of 2006. In Q3 our net income increased to $3.5 million from $647,000 in Q2. We also generated an operating profit in Q3 primarily due to increases in license revenue.

We had an excellent quarter collections. As a result, our accounts receivable days billed outstanding as of September 30 was 66 days, compared to 70 days at June 30 and 71 at December 31, 2006.

Deferred revenue decreased by about $3.7 million from June 30, but is up by about $1.1 million from December 31. This trend is consistent with prior years. One of the largest components of deferred revenue is prebilled annual maintenance fees, as many customers are billed maintenance on a calendar basis, billings in Q1 are almost three times Q3 billings. As a result, this component of deferred revenue shoots up in Q1 and then as maintenance revenue is recognized during the year, the balance decreases.

We have $25.7 million of short and long-term installment receivables. These are installments due to us for term licenses where we have in prior years recognized the revenue on a net present value basis. This balance will be reduced over time as we collect the installments, since we have now changed our license terms so that we recognize revenue for term licenses on a ratable basis.

In Q3 we paid our third quarterly dividend for the year, which was just over $1 million. On June 4, we announced that our Board of Directors approved a third 10 million stock repurchase program beginning July 1, 2007 and ending June 30, 2008. During the third quarterly purchased 418,288 shares for approximately $4.7 million, therefore we have about $5.3 million available for further repurchases pursuant to this repurchase program.

Our cash flow from operations was $6.8 million for the quarter and now stands at $18.1 million for the first nine months of the year. We finished the quarter with $145.2 million of cash and short-term investments, up from $127.8 million at December 31.

As I said, I am asked the Brean Murray Technology Conference today meeting with investors. I suspect that similar to last quarter, one of the most common questions will be about the subprime mortgage problems and its potential impact on Pegasystems. We concentrate our efforts in four primary vertical markets -- financial services, insurance, health care, and the public sector. Based on 2007 licenses filings, financial sectors is not our largest vertical. Through the first nine months of the year, revenue from financial services is tracking in line of last year.

It is impossible to say with certainty how much we may have been affected. While no customer has yet said to us that they are not able to buy software due to the crisis, every day brings more news about huge bank losses, layoffs, and management changes. This daily deluge of bad news can create a state of fear, doubt, and uncertainty that can quickly sour software and other markets.

So, while we are unable to quantify a significant impact on the year-to-date results and in spite of our strong revenue growth, like everyone else, we are concerned about how the magnitude of the issue will impact the economy, customer confidence, spending, and the overall business environment.

Lastly, we give only annual and not quarterly guidance, therefore there is no need to comment on our annual guidance at this time.

So in summary, we had a great Q3. We set new revenue records and made significant progress so far in 2007. We will continue to work hard throughout the rest of the year to both increase our leadership in the BPM space and meet our financial objectives.

I would now like to turn the call over to Pegasystems' Chairman and CEO, Alan Trefler.

Thank you very much, Craig. I will be brief and then we will open it up for any questions that might exist.

I think Craig's comment about the market conditions is on point. You know, it is interesting. We do sell a lot to the financial services industry and I would say that there is a level of tension that is in that industry, coupled with the fact that our business tends to be pretty lumpy and back-end loaded causes us sort of some pause on occasion. Having said that, the team has been executing extremely well. The power of the software is proven in the field and I am very pleased with the results we were able to muster and very encouraged about our prospects as we look to the longer term.

One of the things that makes me so encouraged, even though it happened in October, was our PegaWORLD conference, which you can actually check out on the Web at our PegaWORLD '07 website. We had a record number of customers that came and joined us. We had partners from all over the world actually come and join us, and they came together to engage in over 20, in effect, customer presentations that really articulated -- in ways that sometimes we're not allowed to, but customers can obviously say whatever they want about themselves -- the incredible power that they have gotten from their Pegasystems investments and that the work that they are doing it is really in their businesses quite dramatic.

We had during the last quarter customer go-lives in a wide variety of industries, major insurance companies, health care firms, outsourcers, and banks, that brought Pegasystems technology into production and began rolling it out more broadly in their organization. We continue to get, I think, very good reaction to our product. As we described what our product does to new customers and prospects, it is sometimes a little bit odd, but when they actually see it, they touch it, we have really gotten people to internalize what the potential is.

Many of the customers that we're dealing with are now exploring setting up what they call centers of excellence inside their organizations where they can internally promote what the transformational BPM, Business Process Management technology, can do.

For those of you who are new to the story, what Business Process Management technology does is it basically incorporate the best thinking of the business, allows the business to, in effect, pull that best thinking into a layer that sits above their legacy systems and sort of runs the way that a wide variety of transactions work. Managing customer cases, handling new offers, being able to do everything from writing new business to customer relationship management and call centers, which is turning into a very nice business for us, to creating what we call services and backbones where you can actually do fulfillment, to being able to handle risk, fraud, and compliance by building those factors into the process as opposed trying to audit it in after the fact.

This BPM technology really is quite exciting and I think we're still in, frankly, the early stages of understanding what its potential is and what it can do. Which is why we're so excited to be in the leadership position in the market, but why we are not going to rest on those laurels. As Craig said, we're going to continue to invest and invest pretty aggressively in making sure we build out the product, but at least as important, build out the Pegasystems ecosystem, making it possible for us to be able to, in effect, support our partners as we move to more of our partner-involved model, bringing more expert services into the mix that help those partners and our customers do more work on their own as the business grows, being able to continue to boost our sales and marketing teams, which as we see other companies struggle a bit in the face of the market conditions, we're going to be aggressive about deepening our bench from a sales perspectives and a sales management perspective to be able to go after the market were strongly, and once again, continuing to be committed to being the leader in this exciting BPM space, leveraging our unique Build for Change technology approach.

Relative to that term, Build for Change, those of you before the story may know that PEGA uses that as its tag line. One of the things that I am actually pretty excited about is that term has sort of taking on a life of its own. It is a registered trademark of PEGA, but we were asked and we gave permission to one of the two largest national analyst firms, Forrester, for them to actually use the term Build for Change as half of the way they describe this next major transformation that they see in technology, which they call Design for People, Build for Change.

We think that providing the Build for Change element to the way that people want to think about their businesses will allow the businesses that adopt it to have competitive advantage, to save money, and that this BPM technology, especially coupled with our rules technology, which underpins it, is going to enable both transformational revisions in our customers and still provide a very pragmatic, cost-effective short-term benefit that is what customers, we believe, are going to want as they look, perhaps, at sort of tougher economic times.

So with that, let me opening it up to questions. Lisa, is anybody in queue with a question?

(OPERATOR INSTRUCTIONS) Edward Hemmelgarn, Shaker Investments.

Just a question. A couple of -- could you talk a little bit about the order environment, I mean, just in general in Q3? And then second is how long does it take you, on average, to -- or how much of a lag is there, I guess, is typically when you get an order and is it taking you to actually fulfill all the requirements to accept it or recognize it as license revenue?

I think the order environment has gotten very pragmatic, where folks are looking for generally fairly short-term results, though they are also looking for the long-term potential. So what that means is that the clients we're finding typically want to be able to put something into production and start getting benefit from it in under six months is what we typically see, which is actually lends itself well to this type of software. Traditional software often will have 12 and 18-month implementations, depending on what you're doing. We actually have customers who put their software into meaningful production in his little as 12 weeks, so from that perspective, there is not as much of a lag as you would have seen in other sophisticated sourced software environments.

Credit, do you want to touch on the question around timing of revenue?

Yes, sure. Oftentimes we have customers that are reordering software and our very enabled and are doing most of the implementation work themselves. In that case, for the most part, the software is accepted on delivery and that's sort of one end of the spectrum, as Alan said. A new customer, however, will not be so enabled and will require more professional services, and so the acceptance may slide out for a longer period of time, six, nine months, etc., depending on the length of the project. Does that help?

Yes, I guess what I was kind of -- well, I guess both questions, one is still didn't address kind of the order environment, I mean, as relative to the beginning of the year, what you've been seeing for awhile here. But second, then, is I was trying to think in terms of you talked about you have got $33.9 million I think in term licenses that you've done everything for that -- but have yet to be recognized.

What I guess I was trying to get is can you talk a little bit -- I know that there are some orders out there that you've already gotten, but you still haven't done all the work for. Is that a -- without going into actual dollar terms or something, is that a very insignificant amount or is that -- is there a reasonable lag between when you actually get, or at least with some of these, a term license order and when you begin to be able to recognize, or at least report in your 10-Q?

Okay, so a couple questions there. First of all, the $33 million in term licenses, all the criteria for revenue recognition happens on all those licenses and they are all met before we even put them on that chart. The only thing, of course, is that license revenue is recognized as those payments are made on a monthly or quarterly basis.

In other installations, it does vary, as I say. Existing accounts, the revenue recognition is faster because there is faster acceptance. We do all the time have sort of a backlog of deals that we have closed that we do not have acceptance on and sometimes they're not in deferred. Their sort of not anywhere at any point in time.

Okay.

It is hard to quantify.

I understand. I guess I was not try to get a quantification so much as just more a general --

We are generally finding, though, as we radiate within accounts, those accounts are becoming more enabled and that is our objective, to have the more enabled, and the revenue recognition is definitely faster.

Okay, then last thing, I guess, what percentage of your license orders this quarter were coming from existing accounts versus new accounts?

Alan, do you have those details?

I'm going to look. This is where we are at a disadvantage for not be in the same room. The majority came from existing accounts.

The majority did, so that is becoming -- is safe to say, then, that you're becoming less big deal dependent -- and I'm not try to say they're not any big deals, but just that you're getting a significant flow from then from --?

I believe we disclosed there was about one 10% deal this quarter, so that is a big deal anyway you touch it. We've got a nice mix now of big deals and small deals, but there are enough big deals that have to click in any quarter that you could have a dislocation if they were to slip or fall of the table or there would be a merger, acquisition, or something else that destabilized it. The business, I do use the term lumpy. I think we will continue to be lumpy and so he had, frankly, a larger scale, then the sort of $40 million a quarter run rate we're dealing with and then you get some sort of statistical effect that smoothes it out.

Relative to the question, I think the order environment is not as perky as it was early in the year or last year, but obviously, we are still closing business and able to drive this VPN technology. It is not our style or our approach to sell wildly at the end of the quarter. Unfortunately a lot of software vendors have trained to buyers that they will engage in lots of bad behaviors to do things on the last day or the last week of a quarter and we just don't do that. We have a much sort of longer-term view of that and that also, frankly, contributes to the lumpiness. We won't do a bad piece of business at the end of the quarter.

But having said that, the business is obviously very strong and we're being cautious about the environment, but we would not be investing if we did not think there was going to be a return in coming years.

Just interesting enough, the new accounts that we added in the quarter, quite a few of them were large international banks as new accounts, which is pretty exciting for us.

Okay, great.

(OPERATOR INSTRUCTIONS) Geoff Hulme, Porter Orlin.

I'm just curious, can you help us -- you are probably reticent to give a forward-looking growth rate, but as you -- as you start to do your budgeting for '08 and you're talking about investing aggressively, can you give us some idea of what type of investment growth rate matched to what type of revenue growth rate that you may see going forward? For example, it is a very welcomed development to see operating leverage and positive income from operations and I was just wondering if we can hope to continue to see that with this new level of investment going forward?

I can take that -- and, Craig, you can chime in if you want. We can't really give each other hand signals here. I think you're going to see that we're going to try to invest prudently, so I'm not expecting any major shift, but to the extent that the business is throwing off profit, I think we believe we need to invest that for our future to become the leader in this space. We think this is going to be a fast, fast-growing space.

We also believe that the nature, for example, of our professional services (technical difficulty) is likely to change some and we're going to, in effect, be doing more what I would describe as expert services. But we will occasionally do implementations and that may also have some modest cost pressures in the short term as we, in effect, hire more senior staff who are required to provide the sorts of expert services, as opposed to slews of folks who actually do the implementation themselves, though we have a lot of those people actually on board already.

So we're going to be prudent here as we do it. We're great fans of some profitability, even in periods of strong growth and it was very disappointing last year to not achieve that. This year we are much happier, as Craig said, having put three good quarters together.

Yes, just to give some guidance on revenue growth -- I should not say guidance, but just sort of point out that last year in 2006, revenue growth was 26% over the prior year and this year's guidance, we have guided to similar sort of revenue growth in 2007. So we definitely like growing at that level.

Crag, is there some idea -- because of the way orders flow to revenue, is there some range of order growth that you need to generate that 27% type revenue growth?

Well, our orders -- we're growing a significant backlog of term licenses and that has do with the change in accounting we made in 2006, so that is actually a new phenomenon. As I say, we have had the inventory of those from Q3 last year to Q3 this year has grown $26 million. So in actual facts, those term licenses, those license signings are significantly outpacing the revenue.

But new orders -- to hit it on the head, new orders, if we expect that as a company we wish to achieve about 25% growth rate, or 30% growth rate or whatever, whatever number you want for (inaudible) growth, orders need to be somewhat stronger than that to be able to support it, because not all aspects of the business grow at that rate, as we look to use partners and other organizations for our services, etc. Whatever growth rate we end up having, we think that over the long-term we need an order rate that is somewhat greater than that to be able to support it. That is historically, if you look back at -- it's history. That has historically been true.

(OPERATOR INSTRUCTIONS) Gregg Speicher, Moss Creek.

Nice quarter there. Could you comment on the verticals? Did you get a governmental kick this quarter or anything like that?

Well, as I said, we do concentrate in those four verticals, being financial services, insurance, health care, and the public sector. We have been doing very well in the public sector overall in the last year. Many of those accounts, I know that you were down at user conference and many of them were demonstrating and holding presentations down there, so we're doing very well in that vertical.

We had business in all four of those and good results, I'd say, in all four.

Good, good. I did enjoy the user conference. There was a good vibe there. Did you by chance get a number of prospects that were there?

Most of these were existing customers, but there were some prospects there.

We did have several prospects. I think we have never really stressed that as being a prospect show, though, frankly, based, as you said, on the vibe, which was I think pretty ubiquitously positive, I believe we're going to reconsider that for next year and possibly invite more prospects. But historically, that has been much more customer focused with relatively few prospects. But I can think of a couple of accounts I wish actually showed up, so we may change that.

Keep in mind, we employ a named account model, so we're trying to drive a significant portion of revenue from our existing accounts. So in effect, all those customers are prospects.

Fair enough. Okay, Craig, when you said that it looked like Q4 services would be up, were you trying to say -- usually you have a Q4 sort of drop in the service line. Were you trying to say that it might be up this year?

Yes, it might be. Gregg, you point out something it is very true. Q4 is a tough quarter for services. There is a lot of vacation time and it gets hard to key people engaged. Certainly training as a service drops off in Q4, but we have a lot of business on the go in Q4 and we think the demand is very, very strong.

Great. Last question, any change in the competition?

I think that from a competitive perspective, it is going to be true that we're going to continue to see consolidation. The whole BEA/Oracle is interesting. That frankly actually put some uncertainty in the minds of anybody who is buying BEA. They got to really worry and wonder what is going to happen to that AquaLogic product line if and when it ends up in Oracle. Also I think that TIBCO sort of announced that they were in play, as did ILOG recently, so I think that the competitive dynamic is we are looking like a pretty stable and secure company with our 24-year history. And we're getting a lot of customers asking about that and they appear to be pretty confident with the results. But there have not been any macro changes at this point, I would say.

Great. Thanks a lot.

Ed Hemmelgarn, Shaker Investments.

Craig, just one question. Given you've seen the acceleration in orders and in license revenue over the last few quarters, do you expect to see maintenance revenue to even start to pick up at a little faster pace?

Well, maintenance revenue is absolutely a function of the number of total customers we have. Virtually everybody renews maintenance on an annual basis. So it does have that possibility for accelerating growth as we add new customers each quarter and each year.

Okay, thanks.

(OPERATOR INSTRUCTIONS) there are no further questions at this time, Sir.

All right, to make a couple of concluding remarks, on behalf of Craig and myself, I want to thank everybody who has stuck with us during the various years as we launched ourselves into the BPM business. We're feeling good about the prospects of the business and the prospects of the company, and I want you to know we're all working very hard as a team to deliver on what we think Business Process Management can deliver for our customers and for our investors.

With that, let me say thank you very much and I look forward to talking to you all on the next call.

And that concludes today's teleconference. Thank you for your participation. You may now disconnect.