Pegasystems Inc (PEGA) 2008 Q3 法說會逐字稿

Good day and welcome to today's Pegasystems third-quarter 2008 earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Mr. Craig Dynes. Please go ahead, sir.

Good morning and welcome to the Pegasystems 2008 Q3 earnings conference call. With me here in Cambridge is Alan Trefler, Pegasystems Chairman and CEO. Before we 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, forecasting, could, and other similar expressions identify forward-looking statements which speak only as of date the statement was made.

Because such statements deal with future events, they are subject to various risks and uncertainties. Actual for the year ended fiscal year 2008 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 include without limitation variation demand and the difficulty in predicting the completion of product acceptance and other factors -- affecting the timing of our license revenue recognition; the level of term license renewals; our ability to develop new products and evolve existing ones; the impact on our business of the recent financial crisis and the global capital markets; the negative global economic trends and the ongoing consolidation in the financial services and healthcare markets; our ability to attract and retain key personnel; reliance on key or third-party relationships; management of the Company's growth; and other risks and uncertainties.

Further information concerning 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 year ended December 31, 2007 and other recent filings with the SEC. The Company undertakes no obligation to revise or update forward-looking statements as a result of new information since these statements may no longer be accurate or timely.

As Alan noted in the press release, in this our 25th year, we have set record revenues in every quarter and Q3 revenue of $52.7 million is an amazing record in unprecedented economic times. So we are very pleased with our results so far in 2008. Revenue for the first nine months grew by $37.1 million or 32% from $115 million to $152.3 million. Our net income for the first three quarters of 2008 has increased by 57% over 2007 and we generated almost $33 million in cash flow from operations to end the quarter with $171.4 million in cash and short-term investments.

Given the current economic conditions I would like to repeat what I said on last quarter's call. We, like other software companies, have noticed that purchasing decisions have been impacted by the economy. There are more levels of approval, more signatures required and projects can slip so the ability to predict when a deal will close has been reduced. In spite of these conditions, customers view (inaudible) implementations as a way to reduce operating costs and improve customer service which are still compelling business cases in this economy.

Our pipeline is very strong, but nevertheless we, like all of you, still worry about what will happen to this economy next year. As a result, our salesforce is completely focused on working a pipeline of opportunities where our value proposition is compelling.

On a year-to-date basis, license revenue is up $15 million or 42% from 2007. Most of the increase was in term license revenue which was up by 114%. The total of our outstanding team licenses now stands at $74.6 million. These are non-cancelable term licenses that have fulfilled all the requirements to recognize revenue other than payment for license terms. This $74.6 million is not yet recorded in our financial statements but will hit our P&L in the future as payments become due.

The detail of when these licenses will become revenue are summarized on page 20 of our 10-Q. This summary shows that as of September 30, we expect $6.7 million of this balance will be recognized in Q4 even before we book any additional business in the quarter. Lastly, you should note that these are truly term licenses. At the end of the term, the customer must renew the license or stop using the software.

As I noted in the press release we had a very strong quarter for new license signings. Historically our license signings are seasonal with much higher license bookings in the second half of the year as compared to the first. These second half bookings filled AR and backlog for the following year.

Throughout 2007 and 2008, we've invested in our European sales and professional services organization. This investment is paying dividends of license signings and demand for promotional services in Europe has improved throughout 2008 and was especially strong in Q3. Maintenance revenue was $29 million for the first three quarters of 2008, an increase of 31% from last year.

Revenue from professional services now comprised only of training and consulting services was $72.1 million for the first nine months of 2008, an increase of 27% from 2007. Consulting revenue was up $14.3 million or 27% from the first nine months of last year while training revenue was up about $854,000 or 27% as well.

On last quarter's call, I said that we had one service arrangement where the contract terms required that we defer both about the revenue and cost and this project finished in Q2 and accumulated revenue costs were recognized. This caused an unusual uptick in Q2 services revenue and since we have no other arrangements of this type, it is not repeatable.

As a result, just as we estimated on last quarter's call, Q3 professional services were close to flat from Q2. The demand for professional services is very strong in Europe and so we are achieving new quarterly records for European consulting. However, the recent drop in the euro and the British pound against the dollar will offset this growth when we translate this revenue into US dollars.

Unless these quarters rebound, this currency swing along with a large number of holidays in the US should result in services to be relatively flat again in Q4 and then increase in the new year driven by Q3 and Q4 license signings. Lastly, we had no 10% revenue customers in the quarter.

Our overall gross profit for the first three quarters of the year was $91.4 million, up $21.8 million or 31% from 2007. The largest component of the increase is the $15 million increase in license revenue coupled with a $6.4 million increase in maintenance gross profits.

Our professional services margin remained at 23% in Q3. This was lower than last year as we have been recently been investing in service infrastructure particularly in Europe where we've seen significant demand. 2008 margins were also lower than normal due to the costs associated with our worldwide professional services training session held earlier in the year.

Total operating expenses for the quarter were $28.7 million, an increase of about $1 million from Q2. The increase was almost entirely in the sales and marketing organization driven by commissions on significantly higher license signings and an increase in sales and marketing headcount of 9.25. You should note that we will continue to grow our sales and marketing organization. There is a significant ongoing time with new sales hires so we will hire throughout this year in order to drive next year's revenue growth.

In Q3, our Indian R&D operation was still considered a startup stage and as such costs were included in G&A. However, right at the end of the quarter we opened our new office so as a result, future costs associated with the facility will now be classified as R&D. We believe that continued investment in R&D is necessary to maintain and expand our leadership position in the BPM market.

Our FAS 123(R) charge for stock-based compensation was $829,000 for the quarter, $2.6 million for the first nine months on a before tax basis, up from $1.3 million for the first nine months of 2007. Note 9 to the financial statement details how this charge is allocated to each department.

Our interest income was slightly down in the quarter. Because of the uncertainty of financial markets, we have been moving our cash investments into pre-refunded municipal bonds. These bonds which are secured by escrow investments and treasury bills are very secure and while they provide a lower pretax yield, they provide a good after-tax return. So while on a pretax basis our interest income is down, our overall effective tax rate has decreased to 25.4% for the year compared to 33.6% for the first nine months of 2007.

As I said earlier, we have been investing in our European operations throughout 2007 and 2008. In fact, European sales and services headcount has increased by about 85% during this period. These results have been very favorable. EU bookings in 2008 are up substantially and the service revenue is setting new quarterly records. This increase in business has resulted in greater foreign cash and receivable balances.

From June 30 to September 30, both the euro and the British pound dropped by over 10% with 40% of that drop happening in the very last week of the quarter. This rapid decrease resulted in a $2 million foreign exchange loss in the quarter when we translated foreign assets at a lower rate at the end of Q3 compared to the rate at the end of Q2.

With one quarter to go, our net income is now $8.5 million, up about $3 million from this last year. Excluding the impact of the foreign exchange translation loss this quarter and the gain last year, net income in the quarter would have been $4.3 million, an increase of about $968,000 or 28.9% from last year's Q3.

For the first nine months, we have now generated $32.9 million in cash flow from operations. As I said on this call last quarter, cash flow from operations slows in Q3 and Q4 as there is less to collect but picks up again in the new year when we start collecting larger Q3 and Q4 bookings.

Some of our Q3 bookings increase backlog while others hit AR and increased our AR balances by $1.8 million to $33.3 million at the end of Q3 from $31.5 million at the end of Q2. Accounts receivable days billed outstanding calculated on a quarterly basis is at 50 days down from 63 days at December 31.

We ended the quarter with over $171.4 million in cash and investments. We are very conservative with our investment portfolio. We have no auction rate securities or mortgage-backed securities. We now have minimal risk as at September 30, only 8% of our portfolio was in corporate bonds and as of today, we are not aware of any downgrades.

Deferred revenue decreased by about $11.5 million for the quarter from $40.3 million to $28.8 million and down $4.4 million from $33.2 million at December 31. 47% of the decrease was in software licenses and 36% was in maintenance.

On June 30, we announced that our Board of Directors approved a third $10 million stock repurchase program beginning in July 1, 2007 and ending June 30, 2008. On February 14, we announced an extension to the program, an additional $15 million that would extend until December 31, 2008.

During the quarter, we repurchased 412,398 shares for a total of $5.7 million. This represents an activity level which was about 22% higher than that in Q2. There's a balance remaining of approximately $4.2 million available for repurchases in the remainder of 2008.

In summary, we are pleased with our Q3 results. We know that the economy is difficult and that most software companies have reported how sales cycles are longer and more approvals are required for purchases. Accordingly, we are working hard on solid pipeline to achieve our annual objectives and build momentum for 2009 growth.

With more detail on Q3 achievements, I would now like to turn the call over to PEGA's Chairman and CEO, Alan Trefler.

Thanks, very much, Craig. In these times of macro economic challenge, we are very fortunate that PEGA continues to grow and thus increase market share. The secret as to why is found in our recent PegaWORLD conference held in Washington, DC, where our customer and partner attendees increased 35% from the record attendance a year ago. It's pretty amazing given the major cutbacks that most organizations have put into travel. Their senior management at these organizations decided that it was worth coming to the show to hear what others in their industries and in other industries were doing.

The core message we heard over and over again from these customers which are typically the world's leading organizations is that the level of business agility they get by using our Build for Change technology is enabling them to transform their business. We had 25 client speakers who talked in great detail about how they were using this technology to boost revenue, to improve retention with CRM, to be able to create service backbone to link together diverse parts of the organization and save money and how they were building risk, fraud, and compliance controls into the very process of their business. All linked by an agility and Build for Change message.

In particular, several discussed how they are using PEGA products to increase their focus on customer acquisition and existing customer retention providing specific figures that included increases of cross sell of up to 60%, or major improvements in new business acquisition. Improving customer revenue while at the same time reducing operational costs is a very compelling message despite what is happening in the economy.

As a result, we achieved orders in a wide variety of significant organizations across multiple industries in the third quarter. In financial services, where organizations transforming their customer facing processes and connecting front office to back-office operations. Insurance, the new business processes that happened in both organizations that go direct and through agents. In healthcare, in particular for compact -- contact centers and new enrollment.

In telecom, to enable them to introduce new products faster, better and frankly take their existing assets and put more business through it, one of the fundamental ways organizations do well in tough times. In the government public sector for case management. In travel services, to improve client experiences. And business process outsourcers, to help them rapidly position and right source providing specialized offers to their clients. We actually think that BPOs will continue to be a market that has found significant advantages to using our highly agile and flexible BPM offering and putting together their value propositions to their customers.

We also continued our successful implementation track record with 10 go-lives in Q3, again across multiple industries. Client success, serious customers deploying serious systems is what we believe is going to allow Pegasystems to differentiate itself from other organizations during these tough times.

I was especially pleased that several of the companies talked about our recently introduced directly capture objectives methodology which enables organizations to directly capture into our technology the business objectives they want. So that business and IT work together very collaboratively and very fast to [iterate] and be able to bring technology into their operations and then critically continue to enhance it and continue to change it.

So it was a very, very exciting conference with what was exciting about it was what the clients said. Now we continue and we did announce at the conference and throughout Q3 a number of other important initiatives. We continue to invest in making it so we have the world's best BPM technology and that the solution frameworks and the methodology that we put around that technology is going to give distinctive advantage to our clients.

We are taking nothing for granted because we think the landscape is and will be competitive. And as we come out of tougher times as we all hope we will do at some point, we want to be well-positioned for more customers to be able to take advantage of what we are doing.

Toward that end, in Q3 we announced the industry's first business process management platform as a service offering designed for organizations to be able to deploy BPM as a service internally. This gives big companies the ability to attain the benefits of software as a service through an internal cloud computing approach without the limitations, risk, or performance concerns of traditional SaaS technology which puts the cloud outside the control of the enterprise and frankly introduces all sorts of issues around data integrity, reliability and integration.

At PegaWORLD in October, we also introduced our new federated business frameworks for our industry-leading suite of SmartBPM products. These frameworks deliver the BPM industry's first central management view and a unified world portal for work done across business process management systems that can span the globe. As a result, work can be done across operational silos and provide better customer experiences and frankly eliminate an enormous amount of manual work and manual waste.

We continue to invest in strategic partnerships and we are very pleased with the amount of partnership participation and sponsorships at PegaWORLD. The amount of pipeline that is being created jointly with our partners continues to increase. We see this as a key part of our growth plan moving forward and are going to continue to invest to build these relationships, train these partners, and make it so they carry an increasing part of the implementation services.

Of course we also continue to focus on building out our training curriculum so we can train not just our partners but our clients to simultaneously encourage self-sufficiency and broad use.

Craig mentioned that we are opening India. We are doing this very much to take control of core R&D assets and resources. We think that being able to tap into that intellectual pool of India is frankly not a cost-saving exercise but really a way to leverage our increasing R&D staff here in Cambridge by having another place that we can work that provides a beautiful 7 x 24 round-the-clock development experience where things that can be built here can be tested over in India. Where we can get we think a greater agility as we demonstrated with partners that we have historically worked with in that venue.

We also are continuing the expansion in Europe. Recently we've opened up offices and hired sales and service staff in places such as Germany, Amsterdam and Switzerland. And we are seeing results -- we are fortunate that we already had results without some of these presences so as we make these investments, we are being pretty conservative about doing them in places that we think are more likely to create a good return.

In closing my comments and getting ready to turn this over for questions, it strikes me that our trademark phrase, our brand promise, Build for Change is unusually appropriate at this point in time. Having come out of an election that was all about people seeking and wanting change, seeing businesses under enormous stress from everything from the mergers and acquisitions to the consolidations to the new regulations that are coming, it is clear that we are in a world that is engulfed by change.

Being able to address this with business process management technology, we think can very much improve the agility that lets organizations steal a march on their competitors at this time and that is very much what we are promoting. But we can only do it on the back of client success and we are honored that our clients have continued to choose to work with us and invest in us.

This is at the best of times a lumpy business. And economic issues just make that more so. But when clients see success and they choose to come back and buy more or frankly give references to new customers, that is when the organizations -- well -- are proving by doing that they see value in the technology and that is what we are continuing to invest in to promote.

With that, let me ask, moderator, are there any questions?

Thank you, Mr. Trefler (Operator Instructions) Kevin Buttigieg, Stanford Group.

Thank you. Nice job, gentlemen. Question is about the $75 million in off-balance-sheet term licenses. Just wondering if you are seeing anything there in terms of the amount of renewals that you are doing versus the amount of new transactions, if that mix has been impacted -- what that mix is and whether or not it has been impacted by the economic environment at all?

No, we are seeing both new transactions and renewals positively impacting that number. We are finding actually that at times when it's hard for organizations to go for a capital expenditure that sometimes they are more interested in frankly signing up on a term deal which works well for both of us.

Okay. Your success within Europe, it looks like a lot of that is really coming outside of the UK. Is that correct? And any particular geographies within Europe that are doing particularly better than others?

I am very happy in particularly with Germany and Amsterdam and Holland. I think that those offices that we've opened up have really shown that there was a demand for this product set that we had not then previously working on very aggressively.

Okay. And then just finally. Looking at the cost structure, it sounds like you are continuing with your hiring plans. There are no changes as a result of the economic environment on the sales hiring side or on the services hiring side?

We had very grand expectations when we entered this year and frankly we have dialed them back somewhat just because -- it's actually almost weird to be one of the few companies that is growing, to tell you the truth. We are being more conservative but in the last 12 months or since the beginning of the year, we've added close to 100 people. So we are still growing at a pretty good pace.

Okay, thank you, I will turn the floor over to someone else now.

Edward Hemmelgarn, Shaker Investments.

Just a couple of questions about the business. How do you -- how would you characterize license orders relative to the third quarter over a year ago -- I mean greater or less?

License signings in the third quarter, Edward, were the second-highest in the Company's history surpassed only by license signings in Q4 of last year.

Okay. Where will we -- I just -- it is sometimes a little harder to -- you put out a lot of data which is great. But because of that and since you talk about the term license and everything else it also gives us more data to work with. Was a greater amount of these license signings that you had in the quarter -- where you still have work to do to complete them and that is the reason why they didn't really show up in the numbers yet?

Yes, a fair amount of those license signings showed up and backlog which is not something that we comment on quarter to quarter. We do provide backlog numbers in the K and it is unfortunate it's a bit of an invisible number but they go in a variety of places but this time, we built some considerable backlog.

Okay, so it is the type of thing is that we would expect to see a greater clarity in the fourth quarter then?

Yes.

What about -- let's see -- in terms of just lastly is you had a little pickup in subscription revenue. Is that -- was there any change in orders there or in backlog that you included in deferred revenue?

I really think of subscription and the term the ratable revenue as all being in one bucket as to over focusing on and going up on one versus another. The difference seems to be for the technical difference that doesn't actually have a lot to do with how we look at those individual customers. So as I looked at those if I were you, I would just think of putting them together sort of intellectually.

Subscription doesn't mean that we are hosing or anything. It is just --

Oh no I understand -- I understood you have explained that well in the past. I just was curious because it's also just a number that isn't visible so I was just trying to understand it.

I guess the other thing, can you talk about where -- were there any new markets that are starting to emerge for you, Alan, that are usages that you really -- this year that you have been surprised by and enthusiastic about the potential for growth now and down the road?

I think that the markets that I view as emerging that we are hoping will drive growth in the future is an increased involvement with strategic partners. We are doing much more business than ever with some of the organizations like the IBM Global Services and Cap Gemini for example and Accenture is just three major strategic partners. In addition to some traditional large partners like (inaudible) that we've worked with.

We are seeing them quite interested in using and suggesting our technology as vehicles for them to get value as part of either their business acquisition or their business outsourcing practices. And we do think that this whole BPO idea is one that is particularly well suited to our brand of Business Process Management technology. (inaudible) those people do outsource or move things around but still let the management see what is going on and provide connectivity from the customer service folks and the places where the work is getting done as well as automating a lot of the work which I of course is the best thing to do of all.

So I think this BPO space in addition to the strategic partner spaces are going to be increasingly important as we go into the next year. We are also optimistic that some of the new things we've done in healthcare which are pretty exciting in areas that are called disease or care management will give us some real opportunities in a market in which we are already doing pretty well.

Okay, thanks.

(Operator Instructions) Gregg Speicher, Moss Creek.

Good morning, guys. My first question I think revolves around the fourth-quarter budget flush. Some companies have had differing opinions. Are you getting the sense that there will be the typical 4Q type activity maybe even approaching what you did last year?

I don't think there is going to be a budget flush in the traditional software hope and dreams sort of way. To the extent we sign any business this year, we are assuming it's going to come the old-fashioned way because clients see very specific returns.

We are seeing no hesitation in customers around pushing out spend that they had originally planned for this year into next year and I think that will continue into the fourth quarter.

Great. How about -- so I guess your revenue recognition policy is based on project completion so you are not even seeing the implementation projects being delayed either. Is that what you are saying?

Well, I'll let Craig talk to rev-rec, but --

Our revenue recognition is not always based on project completion. It's based on a variety of factors. We may have situations where it's based on completion but we try and avoid those situations. It's a real mix.

Okay, fair enough. And great user conference by the way. There was a lot of good talk about the new products you were introducing. Is that getting some initial uptick yet or is it still -- is that next year's type help?

I think that is next year. The client -- it was good to see them responding positively to the new capabilities. But we are expecting that this year's results will be based on frankly products that were largely available January 1.

And last question, one vertical you haven't talked about much is the federal/government. Any comments there or new developments?

Yes, we've been making some changes to see if we can dial that up. I think that the federal government has just been one of those areas where we have gone frankly a long time without I think paying the right attention to it. That is something we've made some very conscious changes to hiring people in DC and hiring both experienced sales and partner resources to be able to go after that market.

The sobering thing there of course is there can be long lead times on those sorts of sales and they are almost always partner involved. But we think it should be a terrific market for us. We did sell one piece of business case management system to a government agency this quarter and I'm hopeful that we will continue to be able to grow that business next year quite a bit.

Okay, great. Thanks a lot.

(Operator Instructions) Kevin Buttigieg, Stanford Group.

Could you just discuss a little bit on the financial services side what the impact of the mergers on that side of the business might be having on your business?

I think the reality is we'd all be much happier if these mergers weren't occurring. We've got a lot of experience in the mergers and tend to actually do much better than most systems companies during them because our systems tend to prevail because they're generally much more cost effective than the alternative.

My belief has been for a while that the middle-market of banking was going to largely get consumed. I didn't expect it to happen quite this way and I certainly didn't expect organizations like Washington Mutual and Wachovia to also get absorbed. But we've had a lot of history with this. At one point 11 different companies we did business with were predecessors of now who we call JP Morgan Chase and in the course of that, we were able to actually build an increasingly large relationship with that organization that has turned out to be I think quite good for them and quite good for us.

So we've got a lot of experience and we are trying to push it but there is no question that when a major merger occurs, lots of things that were in flight just freeze and we've seen that happen on a couple of deals during the first nine months of this year.

Okay, thank you. And then, Craig, I recognize you had a couple of unusual items in terms of the tax rate in terms of other income this quarter. Can you provide any guidance for the fourth quarter for the future as to whether those impacts would continue?

The biggest impact we have is moving our bond portfolio to municipals and that will continue to keep the rate down. There are some discrete items that are in the pipeline for Q4 but I couldn't give you the exact details on each discrete item at this time.

What tax rates should we use for example for the fourth quarter?

I think it will be a little bit higher in Q4 but we won't be -- it won't be a substantial variance.

Okay, thank you.

We have no other questions standing by at this time. Mr. Trefler, I'd like to turn the conference back over to you for any additional or closing remarks.

With that, let me thank everybody for listening. I will let you know that the PEGA team is taking the microenvironment very seriously and frankly, we are thrilled that we have been able to grow but it's only because of client success. And we continue to be focused on that, we continue to invest in that and as we invest for growth, I want you to know that we are going to try to do it with the same prudence and attention that we have done over the last several years.

With that, thank you very much and look forward to talking to you when we end the year.

Again, that does conclude the today's Pegasystems third-quarter 2008 earnings conference call. We do thank you for your participation. You may disconnect at this time.