Pegasystems Inc (PEGA) 2009 Q2 法說會逐字稿

Good day, everyone, and welcome to Pegasystems second-quarter 2009 earnings conference call. Today's call is being recorded. At this time, I would like to turn the conference over to Mr. Craig Dynes. Please go ahead, sir.

Good morning and welcome to the Pegasystems 2009 Q2 earnings conference call. With me here in Cambridge is Alan Trefler, Pegasystems' Chairman and CEO. Before I introduce Alan, I will start with our Safe Harbor statement and then provide my financial commentary.

Certain statements contained in this conference call may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words anticipate, projects, expects, plans, intends, believes, estimates, targets, forecasting, could, 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, they are subject to various risks and uncertainties. Actual results for the fiscal year 2009 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 in demand; the timing of our licensed revenue recognition; the mix of perpetual and term licenses, and the level of term licenses and maintenance renewals; our ability to develop or acquire new products and evolve existing ones; the negative global economic trends and the ongoing consolidation of the financial services and healthcare markets; our ability to attract and retain key personnel; 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 the year ended December 31, 2008, 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.

2009 is turning out to be an exciting year. We have now had eight consecutive quarters of record revenue and while only halfway through the year, our net income and cash flow from operations have already surpassed our original 2009 annual guidance. License revenue was $25.7 million, an increase of $9.8 million or 62% from Q2 last year. The largest component of the increase was perpetual license revenue of $16.1 million, up from Q2 of last year by $6.7 million or 70%. Both the average size and the number of perpetual licenses was up from Q2 2008.

Term license revenue increased by 61% or $3.2 million to $8.5 million for the quarter. The total of our outstanding term licenses now stands at $78 million, up from $73.5 million at the end of Q2 2008. This $78 million is not yet recorded on our financial statements but will be recognized as revenue in the future as payments become due.

As we highlighted in the Q, the bookings mix has surprisingly been tilted to more perpetual licenses so far this year so just as we have built up the $78 million of term license revenue backlog, we now have accumulated $28.2 million of other non-term licenses contractual payments that will be recognized as revenue in future periods. The details of when all these future license payments will become revenue are summarized on page 22 of our 10-Q.

Maintenance revenue is $12.2 million for the quarter, $24.1 million for the first half of the year, an increase of $2.1 million or 21% over Q2 last year and $5.1 million or 27% over the first six months of 2008.

Our revenue from professional services finally showed the growth that I had discussed on our two earnings conference calls. Revenue was $26.1 million for Q2, relatively flat from Q2 of 2008 but up $3.7 million from Q1 of this year. Since Q3 of last year, we have seen growth in delivered hours but not revenue to the exchange rates. Demand is mixed as we still see weak demand in Europe but much stronger demand here in the United States. Lastly, we had no 10% revenue customers in the quarter.

Our overall gross profit was $42.3 million, up $11.9 million or 39% from Q2 '08. The largest component of the increase is the $9.8 million or 62% increase in license revenue coupled with a $2 million increase in maintenance gross profits. Our professional services margins was 23% in both Q2 '09 and '08. This is an increase from the 15% margin in Q1 2009.

With more partners doing professional services and as customers are becoming more enabled, we have started investing heavily in training our professional services staff to provide more expert services. This is significant investment as it is necessary to take people out of the field and bring them to a central location for an extended training program. We are pleased with the results to date and therefore we continue to invest heavily in staff training through Q3 and Q4. This investment could have a negative impact on [pro-served] margins.

With economic conditions the way they are, we have been rather cautious with operating expenses. Q2 OpEx was $30.5 million, which shows modest growth over the $29.5 million we spent in Q1 2009. While this caution has had a positive impact of increasing our profitability for the first half of the year, we need to plan for further growth in 2010. So we will grow OpEx primarily through additional sales and marketing staff as well as increased R&D in the second half of the year. We consider both of these expenditures an investment since they will have little impact on 2009 revenues, but we expect them to drive growth in 2010.

Our FAS 123(R) charge for stock-based compensation was $750,000 on an after-tax basis for the quarter. This is less than in Q1 as we refined our methodology with regard to estimates on forfeitures. This is a one-time occurrence, so our FAS 123(R) charge should increase to more normal levels in Q3 and Q4.

Interest income is still down in 2009 when compared to 2008. During last year's credit panic, we moved our cash investment into very safe pre-refunded municipal bonds, which are secure and liquid that pay a lower tax-free rate. This change coupled with an overall decline in rates resulted in the reduction in interest income. Exchange rates moved in Q2 and we experienced a net FX gain of about $2.9 million in the quarter. Our overall effective tax rate for the second quarter was down slightly to 28.5% due to a discrete item. During the quarter, we settled an ongoing audit in the UK in our favor.

Net income for the quarter was $11.2 million or $0.31 per share compared to $2.9 million or $0.08 per share in Q2 '08. Our share count is down from Q2 '08 but up slightly from Q1 '09. We are continuing with our buyback program. So far this year, we have purchased 570,954 shares at an average price of $15.45 per share and at the end of Q2, we still had just over $4 million left in our share repurchase program.

Our accounts receivable balance at the end of the quarter was $32.4 million, down $10.4 million from $42.8 million at the end of 2008. We've had tremendous collections which resulted in a fantastic cash flow from operations of $29.4 million and an AR aging of an amazing 36 days. Our cash has primarily been driven by two components, our net income of $19.9 million and a $10.4 million reduction in AR. While we will continue to be profitable, continuing to reduce AR beyond this level is not possible, no matter how great our collections are.

Deferred revenue can move around from quarter to quarter. While last quarter it increased, in Q2 it decreased from $44.3 million to $36.1 million. We disclosed the individual components of deferred revenue in note 6 to the financial statements.

We ended the quarter with $190 million in cash and investments, up by about $22.8 million from $167.2 million at the end of 2008.

Lastly, let me comment on our revised guidance. Changing guidance in midyear is unusual for us as we think of our business in terms of years, not quarters. I am often asked why do we not give quarterly guidance? First of all, we sell both term and perpetual licenses and the mix between the two can cause quarters to be lumpy and unpredictable.

Secondly, guidance pressure has resulted in many software companies providing crazy discounts to meet their quarterly guidance. You often hear about big stack vendors offering end of quarter discounts of 90% plus, but our business model is to sell additional purpose-based licenses into our existing accounts. A big discount this quarter will set an unreasonable customer expectation for following quarters when we are selling follow-on deals. As a result, we don't give quarterly guidance and we are reluctant to even discuss annual guidance during the year.

Nevertheless, there have been some changes in our business which have impacted our financial results and require us to increase net income and cash flow guidance. While bookings are substantially stronger through the first six months of 2009 as compared to 2008, there have been some usual trends. The mix between perpetual and term licenses has tilted towards perpetual licenses when compared to last year. Perpetual licenses are recognized as revenue faster than term licenses and in the short run, drive up profitability. So the change in our mix is a result of us being more profitable than we had forecast. However, we expect that we can see more term and subscription licenses in the second half of the year, which could result by comparison to the first six months a lower level of profitability but with even higher backlog going into next year.

In addition, given the state of the economy, we have been cautious about spending; however, given our results to date combined with our backlog and our pipeline, we will be more aggressive with our investments in order to sustain our revenue growth into 2010 and beyond. We will be investing in sales and marketing stuff. Further expansion of our R&D team and training for our [pro-serve] staff, further expansion of our R&D team, and training of our pro-serve staff as we move to more expert services.

As a result of these factors, we have increased our annual guidance for net income from $17 million to over $25 million. The front-end loading impact of more perpetual licenses is also true of cash flow. Term licenses by their nature spread the cash flow over years. As a result, we do not expect our cash flow from operations to be as great in the second half of the year. Accordingly, we have increased our guidance for annual cash flow from operations from $25 million to $35 million.

Now with more detail on Q2 achievements, I would now like to turn the call over to PEGA's Chairman and CEO, Alan Trefler.

Thank you very much, Craig. Thank you for the strong operational performance of your staff. The reality is that PEGA had a very strong Q2 broadly across the Company. Introducing our eighth consecutive record revenue quarter, we have clearly increased market share in this important area of business process management. I like to think about longer periods as good quarters as well, so I will talk primarily about the first half from a number point of view.

The over 60% growth in license revenue really shows that despite what is a brutal economic environment, customers are willing to step up and buy. Out of this past quarter, we had customers in banking, insurance, healthcare, life sciences, pharmacy benefit management, travel, transportation, e-commerce, all purchase Pegasystems Build for Change technology. We showed this really also is complemented by a significant increase in investments from some of our key strategic integration partners. We very, very consciously made sure that we are creating capacity for these partners.

If you take a look at the license revenue growth of over 60% and a services growth in the teens, you can see that we are creating headroom to support these organizations as they create practices. These are all important strategic initiatives for us and are all key to where we think we want to take the business as we go forward.

Among customer purchases in Q2, some really come to mind. A Fortune 50 pharmacy benefits company purchased our software to implement a new level of agility broadly across lines of business in multiple areas of operation. A large healthcare payer purchased our Build for Change technology to dramatically reduce costs and improve their customer experience in the way that they handle claims. A large travel and transportation firm extended their purchase of Pegasystems software to significantly improve the customer experience in contact centers. And a major international global bank purchased our software to in effect revitalize the way they interact with customers, to automate exceptions processing both in the back office and stepping into the front office, taking out costs while improving service.

This marriage of service and productivity that we offer to our clients and many of them have experienced because so many of our clients come back to buy more is central to what our value proposition is and central to our mission and actually central to why the Company has continued to do well despite what is a truly brutal, brutal buying environment out there.

We are seeing this reflected in an area we sometimes refer to as Smart Case management. This is where you create a service backbone that allows you to capture enough information about our customers' customers' transactions, put enough process and rules around it, and give the business people enough agility that they can actually manage the business better, decide if they want to offshore things, keep them onshore, or best of all, automate them to improve the client experience.

Our technology is unique in that it really improves the transparency of how these complicated global operations are running and putting command and control and case automation in across operational silos really lets organizations do a more effective job. We call the overall approach that we are taking the ability to wrap and renew our client systems. We don't go in and tell them that they need to rip and replace large legacy infrastructure. We say they can revitalize it, that they can actually add the capabilities they need, add the agility they need, but still maintain a lot of their legacy environment unless or until they are ready to make those investments independently.

This ability to utilize existing systems is central to the technology and frankly a key part of our heritage, where we have always been insinuated in mission-critical and important backend systems. This sort of pitch resonates much better than dig back approaches and the deliveries that our customers are having into production actually reflects the fact that it is a much more reliable way to implement software.

We had a record number of go-lives this quarter, much more than in Q1. We had 19 significant client systems step forward in Q2. And that is a reflection of both our clients learning how to apply the software better, and obviously that we have been selling more of this technology. But ultimately this client success is very, very central to the growth of our business and is something that we are going to continue to invest in and we're going to make sure that we can have a product that is easier for our clients to use and a product that our customers can increasingly deploy.

Our investment in this distinctive technology continues in Q2. We released the latest version of our what we call customer process management technology, which really provides an intense driven customer experience in the Customer Relationship Management area. This is often used to automate call centers, but also provides a basis for multichannel customer service. We are having very significant interest and success in the multichannel contact center business as customers are finding that the sort of old data-driven approach to customer service doesn't provide the improvements they need and are looking for ways to insinuate more process, more rules, and more flexibility in the way that they interact with their customers.

The ability of our customers to rapidly design and implement business solutions is also supported by our methodology. We have released in Q2 some interesting new features around using our technology to manage the process of implementations themselves. We've added a project management framework and a test management framework to really help attack the challenges of how do you run complex and sometimes multijurisdictional projects? And how do you reduce the testing overhead, which will further allow agility to be increased by our clients in the future?

Our data shows that the use of this new methodology and these frameworks can reduce the time and costs of implementing these systems by 30% or more, and we think that is so consistent with our Build for Change message that once again, we are going to continue to grow these and other complementary technologies that will help our customers be more successful.

So in terms of where we are looking to go and what we expect for the future, we think we are in pursuit of a very important opportunity. The area referred to as business process management to me e really should have been named business process automation. It's about getting the benefits of automation with a real business flavor, allowing successive implementations, and having large customers have the confidence that they will be able to extend their systems into different areas, different markets, and that Build for Change flexibility, which has been our mission from the beginning.

This is a sufficiently important opportunity that despite the fact that the economy is still (inaudible) -- who knows when that's going to change -- we think that our strength in the first half really should power an increase and somewhat less conservative investment strategy in the second half.

We are looking to expand our business to make sure that when the economy loosens up that we will be in a good position. This will lead us to broaden the salesforce, entering some additional verticals, still focusing on trying to capture the imaginations of the thought-leading organizations in different and new verticals. We will be adding to our frameworks. As some of you may know, our frameworks are pretty significant out-of-the-box intellectual property packages that enable organizations to really get a jumpstart and also make this vision of automating processes much more real and much more tangible and also makes the companies more effective.

We are going to be deepening existing frameworks and pursuing new verticals with the addition of frameworks to help us get insinuated into those. We are going to be deepening our support organization because we think maintaining client service is very, very key and our customers really care that they can depend on us on a software or a technology that there is a support organization that is able to make sure that they're going to be successful.

We are going to continue to grow the services organization, but very much as part of our focus on driving more implementations through partners, not partners who are frankly just there to sort of provide hours, but partners who really get the vision of thought leadership and really are going to help our customers understand the many ways that they can apply this Build for Change approach to the way that they do their business.

We are going to increase our focus on multichannel customer process management, trying to make sure that some of the antiquated call centers that I think are going to be up for wrapping and renewing or replacement next year really have a strong opportunity to engage Pegasystems to be able to provide that. And once again, our [con] initiative, which we have signed up with Amazon, the (inaudible) cloud computing initiative, and we're going to be offering some very interesting Software-as-a-Service opportunities to our clients.

Given who our clients are, historically they have been a little nervous about putting data out on the cloud and we think a lot of them in production systems are still going to want to maintain their control. But the fact we have a cloud-capable platform is going to provide a lot of degrees of freedom to our clients, those who aren't as worried about the data issue and those that want to use that technology to help them build systems more rapidly, handle development and testing and other key initiatives.

So the final initiative that we are excited about here is once again that whole partner ecosystem, and you're going to see a real aggressive focus in the second half because we want to make sure that we are broadening our approach to the market so that we can be in a position to really take advantage of what we think would be a pretty exciting opportunity going forward.

So with that, I sort of concluded my thoughts on the quarter and would be very happy to open it up for any questions you folks might have.

(Operator Instructions) Nathan Schneiderman, Roth Capital Partners.

Thanks very much for taking my questions. I have a few of them for you. Craig, in your prepared comments as well as in the Q, you all have disclosed non-term license backlog off the balance sheet at 28 -- approximately $28 million. And I was hoping you could share with us what some of -- what the prior few quarters have been and also the year-over-year number there?

Yes, Nate, thanks for calling in. Yes, that number has been growing substantially and it got to the point where we decided that it hit such a level that would be meaningful for the investors. So we've included it. We can't comment on prior numbers as we would have to then go back and redo the calculations and file some supplemental data in giving what all those numbers are. But we will definitely be posting that number going forward.

Can you give us a sense --? Did this number kind of in a broad brush way decline sequentially, grow a little bit sequentially, grow a huge amount sequentially?

It's actually pretty strong for Q2. As you're well aware in our business normally Q2 and Q1 are quarters where bookings are lighter than they are in Q3 and Q4. So it was actually quite an accomplishment that we managed to build a significant amount of future backlog in the quarter.

Can you more generally -- can you talk about the quarter on a bookings basis rather than on a revenue basis? What do you think of as the dollar amount of your bookings during the quarter?

We try not to give dollar value of bookings because there is no standard of what bookings are and what we call them would be different than what a lot of other companies call them and it gets confusing. But we did say both on the call and I believe in the Q that bookings were actually up substantially for the first two quarters of '09 compared to where they were in '08.

Can you comment about the term bookings in particular since we do have those numbers in the Q?

As I said, a lot of times when the economy is soft, a lot of people were saying to me, gee, this would be a great time for term bookings. It helps customers get deals under the radar and get approved because they are small when people look at them in terms of terms. But you know what? This was somewhat -- this first six months was somewhat of an anomaly. We track the ratio of term to perpetual over history and for some strange reason, it definitely tilted towards perpetual. Now we don't think that's the case in the second half. We have a pipeline. We think that terms and subscriptions will -- the pendulum may rebound.

Okay, just kind of shifting gear to the cost and investment side, Alan, you and Craig have made a number of comments about investing in various areas of business and in consulting and support, and sales and marketing and R&D. If we consider the operating margin for the first half of the year approximately 20%, where do you think these investments are going to drive operating margin down to in the second half of the year?

Well, as I say, we give a new guidance number for net income. I am sure in your model you will tweak to see how you can get to close to those numbers, but these are not unusual investments for us. This has been the same strategy that we've employed over the last three years and as a result, we have been growing revenue at close to 30% for last three years by making these same investments, more salespeople, better salespeople, more R&D to evolve the product and more marketing. It's been highly successful for us over the last three years.

Look, over the long-term, there's no question that software companies get enormous improvements in operating margin as they hit certain scales. But I think it's pretty important that we are growing the sales force and we are growing some of the other key investments like R&D and other functions at a rate that is more consistent with our overall growth rate or license growth rate, because otherwise you end up not being in a position to have the potential even to feed the machine a couple years out. So that's what's driving it.

Got it, and final question area for you. Just you did speak to some kind of increasing success in the call center environment. I was curious what percent of your overall business would you say is now call center driven? Where would that have been last quarter and the year ago period? Also same question in the financial services. Thanks very much.

I don't have specific numbers, but I will tell you that things that involve customer service, including front-line customer service that could touch a call center and a branch, I would say is at this point probably well up over a third of our business and I would tell you I think it's been increasing in the last year or two. And I think one of the reasons frankly we want to hire some senior people to help us deep in this business, we're looking for actually a Vice President of a CRM practice if anybody knows anybody. And we really think we want to go after that more aggressively because our clients have had such tremendous success as they've used it.

Sometimes is their entire customer service desktop, but other times just to embed processes into their existing desktops. So I would say that just an important way to deploy process. And relative to financial services, Craig?

We continued to sell into all verticals in the quarter, which is consistent with prior years, although I must say that our success in financial services was even greater in Q2 than it was in Q1. I certainly read in the papers that there could be signs of recovery there and certainly the revenue that we achieved from that vertical seems to bear out that fact.

Thank you.

Raghavan Sarathy, Dougherty & Co.

Thank you, thanks for taking my questions. First, on what Alan talked about in terms of investments in pursuing new verticals, Alan, could you give us some sense of what some of the new verticals you are going to be pursuing, what type of frameworks you're going to be building? And then you also talked about building the partner ecosystem. Does it mean that partners are going to be doing more of the services work? Can you give us some color on that?

Yes, I would start with the second. Partners are already doing a lot more of the services work. You can figure out some of that by just comparing the license momentum with the service momentum, and that was really quite conscious as we go forward. And we think that there are a variety of partners that we would like to deepen our relationship with and use that as a vehicle to frankly help customers get it. This is a technology where it's not always obvious how you apply it and having people who are experts in lines of business I think is also going to be very helpful as we move into new verticals as well.

Relative to new verticals, there are some very obvious candidates here. You've heard me talk a little bit about for example the telephone providers, where we have actually had and discussed over previous quarters that we won a couple significant pieces of business in that area without really having the vertical specialty areas such as travel and transportation are also places where we think there is opportunity.

Pharmaceuticals, we've sold significant systems to a couple of major pharmaceutical firms. By going into verticals where we already have something of a footprint and have some internal references, we think we'll be able to build up some frameworks and monetize that next year more easily than just doing things that are wildly different.

Just as an aside, more partners doing professional services means that we are evolving our professional services staff into more expert services, so we are updating all of their skills as we talked about on the call.

All right. And then in terms of the cash schedule that you disclosed, just kind of a clarification question. This non-term, the license that you disclosed here, have you met all the revenue recognition criteria for the $28.2 million that you disclosed here? And essentially you'll recognize revenue when (inaudible) or how should we think about that?

Yes, we have met all of the revenue recognition criteria other than customer providing payment. Some of these are extended payment terms, which include additional rights of the software. And they are contractual payments and so as these payments become due, we will take them as revenue.

Great. Then on the deferred revenue, I noticed that deferred revenue declined by $8 million sequentially. It looks like all of the decline came from software. Is it right to characterize that basically that was due to the perpetual license that you recognized in the quarter? And also, Greg, you made the comment that you are going to see more term than perpetual in the back half of the year. What does it mean to deferred revenue or how should we think about the mix going more towards --?

Well, deferred revenue, I try to deemphasize changes in deferred revenue because it can really bounce around a lot from quarter to quarter. You know, we may solve a licensed deal, but we are still negotiating the professional services so it fits in deferred revenue. It's usually a couple deals. It moves around. It's not significant. It certainly doesn't do much to provide any indication of long-term trend of the business.

So that would go into -- basically the -- balance sheet? We may not see improvement on deferred?

Correct, occasionally a very little bit of it will go in deferred for some very esoteric reasons, but you are right, it may not. But then again, as much as I say that, there could be one perpetual deal that closes at the end of the quarter and it ends up there. So I really try not to read too much into the way that that bounces around a little bit from quarter to quarter.

And then if I can go back to the first part of the question, so the sequential decline I do understand that we shouldn't read too much into it, but the sequential decline was related to a perpetual license that you recognized out of deferred. Is that the right way to look at it?

Yes. We give the details. We are one of the few companies that breaks out all three components of deferred revenue and that's in note 9 I believe to the financial statement.

Okay. Thank you.

Brian Murphy, Sidoti & Co.

Thanks for taking my question. Craig, you mentioned that licensed bookings were up substantially in the first half of '09 versus last year. Can you just talk specifically about bookings in the June quarter versus '08?

In both Q1 and Q2, bookings were up substantially over the similar periods in last year. It was consistent in both quarters.

Okay, and it sounds like you guys are getting some pretty good traction around call centers. Can you just speak to win rates in that area?

I think our win rates are actually pretty high. I would say that when we're actually competing, doing sort of bake-off or comparison, our win rates I would say are north of 50%. So remember, when we go into a call center we don't -- sometimes it's not a traditional monolithic call center implementation. We are really trying to insinuate process and more agility into the existing system. So the last thing clients really are psyched about doing these days are massive call center implementations.

Yes, and you know, Alan, just a sort of follow up on that, can you just give us a little color on how you are doing with the Tier 1 service providers?

Yes, you mean the systems integrators? We are actively engaged with the three that we have really been working to focus on have been Accenture, have been obviously IBM Global Services, and Capgemini. And we have actually brought on additional staff and new staff to work with them, and we're seeing very, very significant interest and some meaningful increases in trained personnel from those three Tier 1 providers.

And I think some things like the call center, which we position as part of what we call the service backbone, which is sort of an element of getting rid of the silos between front office and back office [of the] the parts. That sort of service backbone concept I think actually plays well to how those guys have engaged historically with their clients.

And Craig, maybe one for you. The pretty substantial uptick in the service gross margin. How should we think about that for the back half of the year?

Well, as Alan pointed out, we have new and a lot more partners doing professional services and as a result, we don't want to compete with them on a day-to-day basis, but what they take value from us for and what customers like to look to us for value is really top-notch expert services. So we have taken upon ourself to tremendously invest in upgrading the skills of all of our professional services people. We want to have them all certified. We want to improve their level of certification. And that's not an easy process.

We have to take these people out of the field, which means they are no longer billable. They have to cover up somebody else and we bring them to Cambridge and they have extensive training programs to upgrade the services. In fact one of the programs is -- how long? A nine week program, so for nine weeks these guys are out of the field. They are here being trained and we've run it once and found it very successful. And we are going to make a real push on that for the rest of the year. So that will have the impact of lowering professional service margins.

Okay, so maybe for the back half of the year something similar for what you guys put up in '08 in that vicinity?

Yes, it will definitely be down from what it is now.

Okay, and just to try to get maybe some color on the magnitude of the ramp-up in R&D and sales and marketing, sort of as a percentage of sales in the back half of the year, what can we use as a gauge? Maybe -- should we model those line items sort of at sort of historical levels going -- the past two or three years?

We are going to look to increase the staff at faster than historic levels simply because our license revenue has grown as faster than historical levels if you go back a couple of years and we see the desire and need to create some additional capacity.

I think we were a little worried about the economy coming into this year and frankly, we are a little bit conservative, which you have seen in the bottom line. And we want to be very conservative about making sure we hire highly talented people. So we're going to be careful, but we do think that we need to increase those staffs at a faster rate than we did over the last -- average for the 12 months.

Okay, thank you.

Gregg Speicher, Moss Creek.

Good morning. Can you talk about the linearity in the quarter?

Yes, this was actually from a revenue perspective and a bookings perspective, this actually was a pretty good quarter, but there's not consistency in the way that works. Sometimes things back up to the end because clients tend to do that and sometimes you get fortunate because stuff that backed up to the end and spilled over actually signed early in the new quarter. So I didn't see anything remarkable at all about linearity, frankly, in either of the first two quarters of the year.

So looking at a decrease in the on-balance deferred revenue versus the off-balance going up a sign of like deals signing late and not being able to be on the balance sheet, is that not fair?

I don't think that's necessarily the case, Greg. It's more a case of contractual issues that depends on whether they end up on the balance sheet and in the off-balance sheet.

Okay, okay, fair enough.

You can see a lot of that off-balance sheet is actually out a year or two, so whether it could happen a couple weeks early or not, I don't think (multiple speakers)

It doesn't really matter. It's still -- the linearity moves around. I'm still waiting for a third quarter where I could spend -- or a third month where I could spend most of the time golfing, but it never happens.

We would love that, wouldn't we? And then on a sequential service revenue increase, I found that interesting as well. As you know, most license companies have been having downturns in their service business. Is that -- was there some one-time stuff in there? Should the service level come down in Q3 or what do you think about that?

Well as Alan said, we had a record number of go lives, so that means our professional services people were engaged at record levels. We expect professional services to grow to the rest of the year. As I said, we're seeing pretty strong demand in the US. Weak in the UK and in Europe, but we think that will over time will come around. They seem to lag behind us, but it's going to be -- we are not going to see anything like the growth that we have seen in the license revenue, and a lot of that is because our partners are doing more work.

And the certification programs, we have added two additional levels of certification that are going to be available to -- the first is already available to our partners. The second will be made available to our partners in the second half. But by trying to create a more formal layer of certification, we are looking to give clients a really solid way to understand what they are getting when they deal with a professional service person. PEGA or a partner, we have to lead that. Our own -- we've actually got people who I think will pass the certification levels quite easily, but we're going to have to take some of them out in the field and make sure they're fully rounded and frankly invest in their education, which I think is appropriate.

Okay, last question. As I've been going to your user conferences and then just talking to people in the field, it looks like the ways people are using this just seems to be growing tremendously. First, am I wrong there? And B, is this product more horizontal than you thought or partners just finding new deals and new usages or are people just hearing about it and saying hey, that would be cool to automate this or that for?

We think the product is -- has the potential to be quite horizontal; however, it's a different way of thinking about how you have frankly business and IT work together. We find that going to market through verticals gets clients to internalize it. But I'm actually pretty excited by the very broad breadth of utilization of this technology that we are seeing. And we're seeing it used for things that we would never have imagined, to tell you the truth, which I think is a good sign.

Great. Thank you very much.

Laura Lederman, William Blair.

Thank you for taking my questions and good quarter, guys. A few questions. One is how visible is the mix of perpetuals versus subscription and term? In other words, when you went into the first half, did some deals that started out subscription and term end up being perpetual? So I guess what I'm trying to get at is how clear is that shift that you are expecting in the second half back to term and subscription?

Well, you know, when Craig adopted my classic word lumpy in his discussion of events, one of the things that makes this lumpy, software business is just lumpy by its nature and I almost hate talking about record revenues quarter after quarter. We kind of love it, but sooner or later something always happens. The reality is we have a lot of visibility into our pipeline and our pipeline is strong. Whether that will close as the term deal or as a perpetual actually can change at the very last moment. And I kind of like the term deals. Given my druthers, I think the reliability in the visibility and the discipline of having a term relationship with a client just puts a lot of things in the right place. I felt that frankly more strongly until the more recent prices when customers started running into bankruptcy courts. We fortunately have never really had a problem with that and that kind of made me think perpetuals might be better.

But we see this flip around and I think as a result between the overall income statement of the firm and some of the other disclosures that Craig and his team are putting forward, I think we're trying to provide them -- our community pretty good visibility into what's really happening in the Company. But we will flip the arrangement in a heartbeat if we think it's better for us and still a good deal for the customer.

Second question which is you talk about the three major SIs. Are you looking to add the number of SIs or simply have these three SIs that you focused on continue to increase their staffing around you guys?

So we -- I do expect we will add some additional system integrators -- certainly we get nonstop calls. But sort of culturally I'd like to see us continue with targeted model and we are still early in our journey in getting these SIs to be able to do what I think they can do in their customer bases and with our technology. I think you'll see us add additional SIs as we bed down some of the early ones because that is just kind of our style of going to market in general.

Can you talk at all about the level of increase of people? I realize you can't or maybe don't want to be specific as to which firms, but can you talk about in some level the increase in the number of staffing? You referred to that? Did it go up 30%, 20% in terms of the SIs dedicated to PEGA?

The level of activity and some of the commitments that have been made have been -- in some of these cases, we are operating off of small numbers, but there have been commitments to doubling some of these organizations practices. And there's a very large ecosystem of system integration partners that are practically chomping at the bit to do some of this work because frankly they see the license revenue growth and they've got clients who are calling them asking them if they can do work.

Great, and one final question from me. What percentage of business are now selling with frameworks if you look at like the first six months of the year?

I'd say a lot of it is selling with frameworks. We have introduced some frameworks that are really sort of horizontal frameworks as well as the vertical frameworks that we traditionally did. So for example, we have frameworks that help the systems do self tuning, what they call autonomic services and self-healing in a lot of cases. So between the vertical and the horizontal frameworks, I would say the significant majority of the technology is selling with one or the other at this stage.

And as a final, final question, can you give us a sense of how much of the business today is in different verticals, just [piece in] roughly?

We actually as I mentioned in my opening, we actually sold and delivered in the first half of this year and actually also in Q2 very broadly across verticals including verticals that were kind of new to us in some ways. We still have a fair amount of business that comes out of financial services and I actually think that is a real test of the firm that we can get organizations, all of whom are extremely focused on return on investment to think that investing in PEGA makes sense. I think that it's perhaps a harbinger for good things when markets return to sort of reason at some point in time in the future.

But we are still -- I don't think our vertical concentration has particularly changed over the last couple of years with the exception that healthcare has gotten really quite strong, I would say. And some of this new pharmaceutical stuff has gotten quite strong in the last 12 months.

Thank you so much.

Richard Davis, Needham & Co.

Thanks. I had kind of two general questions and what I am trying to figure out is why next-generation BPM has reached a tipping point and what that means for your addressable market. So as you know, you touched on this in your prepared remarks, but the Big Bang rip and replace deals are gone and you kind of saw that in some of the bigger firms like SAP's numbers. So two questions are this.

One, do you agree that the market you are attacking, it seems to me when I do -- looking at it it's well less than 10% penetrated. And two, and this is -- I'm trying to figure out if this is an issue for you guys at all -- do you think that the enterprise upgrade cycle for Windows 7 will compete at all with you for budget dollars? So those are the two things. You have kind of an easy and a harder question.

So I think that relative to the Windows 7 question, I don't think it's going to be relevant at all. Our implementations, the vast majority of them are paid for by either operational savings or in some cases the ability for the client to enter a new market. And the infrastructure upgrade cycle, I don't see that having any impact. Frankly, I don't see a lot of my customers rushing to adopt Windows 7 in the next 12 months anyway. They're going to want to see how that beds down.

You mean their stuff comes out with bugs in it initially? That's inconceivable.

It's hard to believe, shocking. We still have to worry about being able to support it of course and whatever exciting new things like IE8 and other browser types. But in terms of a tipping point, I'd don't think BPM is really at a tipping point yet. I think we are still -- I'm a little surprised by this, because I thought we'd get to a tipping point sooner. But I think we're still in kind of an early adopter trying to understand what it all means market. We've got a lot of different classes and types of companies saying that what they have is BPM and I don't think the market has entirely figured out what it is.

The thing that makes me glad is that the companies who are all calling what they have BPM are actually doing meaningfully different things just objectively. And from my perspective, we think our vision of where BPM needs to go is the right one and ultimately the market will prove that or not.

Got it, that's helpful. Thanks.

[Jeff Osher], Harvest Capital.

Thanks for taking my question. Now, the change in accruals sequentially for year-over-year, is that just a function of bookings being down? I'm just looking sequentially accruals fell by about 30-plus%, accrued expenses specifically, and then year-over-year it looks like they were actually down from 9.4 to 7.8.

I would suspect without delving into this in any detail that in the UK and in Europe, our professional services business was down. As I said, there's a weaker market, so what happens is the first thing you cut back on is subcontractors that do professional services on our behalf. So as that economy gets weak, you cut those guys out first and keep your own people more engaged. So I suspect that's what you're seeing there.

How would that be an accrued expense?

Because we oftentimes are on time and material to these people. We have to bill and we don't get all the detail from the vendors.

So it is related to a percentage of completion on the maintenance or -- I'm sorry, on the services side?

On the services side, it's usually T&M.

Okay, fantastic. Then just second, just as it relates to the question one of your -- someone was asking earlier about the $28 million of license payment you are disclosing this quarter, you mentioned earlier there were some extended payment terms. Is that something that is -- are you seeing that more across the Company or is that something that is -- have you always offered extended payment terms to customers?

Well, you know if you think about it, a term deal is a form of extended payment terms over as much as five years. So a lot of it depends whether -- there are nuances I think of structure that cause it to go into one bucket versus another. And it also is kind of a small number of deals can actually affect the numbers. So I don't think that there's any meaningful shift. We have offered extensive payment terms in the past on perpetual licenses and other types of licenses. It's just that the numbers have now gotten big enough that Craig and the team thought it was appropriate just to start explicitly disclosing it.

Thanks a lot, guys. I appreciate you taking my questions.

Edward Hemmelgarn, Shaker Investments.

Yes, great quarter. Great six months, as always. I've got a couple of questions. One, Alan, when you look at your implementations, what percentage would you say is now being done by internal staff of the companies or that are buying the software? What is done by PEGA and what is done by external non-PEGA consultants? How has that changed over the last couple of years?

Well, you know if you think about all of the people who actually are involved and actually implementing this staff, what's changed over the years is over the last couple of years the population of folks who are not PEGA employees were driving implementations are actually doing implementations. Its a combination of partners and customers themselves has gone off massively and I would say at this point we are contributing -- I would say we are contributing less than 10% of the work that goes into putting up Pegasystems around the world.

Okay, great. How much is -- what would you say is being done by internal consultants?

Of the rest of that, I would just viscerally, I would say that the split between internal and external would probably be 50-50 or so.

Is that what -- one of the things that's really helping you drive your ability to increase sales and implementation and everything else? Or I mean it's just that you've got more evangelists both internally and externally?

I think evangelists (inaudible) even better are client successes and so I think what's driving a number of these sales is that existing customers are finding that -- that worked well. Let's do it over there and those obviously are some of the sweetest wins to get because they are based on a very knowledgeable buyer. They are purchasing something with a high level of confidence that they will be successful.

Okay, government consulting, you mentioned that was an area that you were really hoping to target to increase, and I was wondering have you -- can you talk a little bit about that? And then second is, are you working or trying to really work with some of the traditional government consultants more?

Yes, we're trying to work with some of the traditional government SIs, but to be frank on the last call, I talked about how our government work was very much an early work in progress. And I will tell you that it is still a very early work in progress. We have not advanced that ball as much as we need to, and that's one of the places we're going to do some of the investment.

Okay, and then in terms of R&D, how is your India center doing now?

We are very, very excited. We are continuing to expand our R&D presence in North America, and primarily in our Cambridge offices. So we don't see this as an alternative to the states. We just tapped into a rich vein of talent and we are extremely happy with the way that that is off to a new start. And are actually contemplating doing an expansion in India as well.

Okay, great. Thank you very much.

And with that, I think are going to bring the call to a close. We appreciate everyone's interest and I want everyone to know that we're working hard for you. Thanks very much. Talk to you next month.

Once again, ladies and gentlemen, that does conclude today's conference. We thank you for your participation.