Pegasystems Inc (PEGA) 2010 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Pegasystems Inc. third-quarter 2010 earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session with instructions following at that time. (Operator Instructions). As a reminder, this call is being recorded.

Now your host for today's conference, Craig Dynes, Chief Financial Officer. Please begin, sir.

Thank you. Good morning, and welcome to the Pegasystems 2010 Q3 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 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, believe, 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 fiscal year 2010 and beyond may 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 are contained in the Company's press release announcing its Q3 2010 earnings and in the Company's filings with the SEC, including its reports on Form 10-K for the year ended December 31, 2009, 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.

Q2 was another history-making quarter for Pegasystems. For the first time, the Company exceeded $90 million in GAAP revenue in a single quarter. I say GAAP revenue because due to the complications of purchase accounting, we've provided non-GAAP financial information in our press release. Like other software companies, we have excluded acquisition charges, amortization of intangible assets created as a result of purchase accounting, as well as equity compensation charges. This allows easier comparison to other software companies, as well to analysts' models who use these non-GAAP business measures.

GAAP or non-GAAP, Q3 was our 13th consecutive quarter of record revenue. Non-GAAP revenue of $95.4 million was up $30.6 million or 47% from Q3 2009. Our business is typically much stronger in the second half of the year, and as expected, 2010 is proving to be a very backend-loaded year. As an example, license revenue on a non-GAAP basis was $36.5 million, up $7.2 million or 25% from just last quarter. Q3 license revenue was driven by a significant increase in new license signings and an increase in average deal size compared to the first half of the year.

In addition to higher bookings, there was a slight swing to perpetual license bookings in Q3. For the first half of the year, new license signings or bookings are mostly evenly split between term and perpetual licenses, while in Q3, perpetual licenses accounted for close to two thirds of new license signings. The mix between perpetual and term licenses is driven by customer circumstances and can cause quarterly license revenue to be lumpy and somewhat unpredictable.

Both term and perpetual new licenses signings were much higher in Q3 than they were in Q2. Similar to last quarter, on a year-to-date basis, new license signings are higher this year as compared to last year in every vertical other than US healthcare. Our healthcare vertical was slower in the first half of the year due to the temporary uncertainty related to the Federal Healthcare Reform Act. However, there is now very strong activity in this vertical. The value of healthcare license signings was up significantly in Q3, and there is a very good pipeline for Q4.

While we concentrated our sales efforts on target or named accounts, we were also growing our customer base. Through the first three quarters, we have closed more than five times the number of license arrangements with new customers as compared to the first three quarters of last year. With the additional sales people we have brought on board, we are covering more accounts, more geographies and more partnerships.

Partners continued to be an important part of our revenue growth. Partners are associated with about 38% of all active opportunities in the pipeline. Partners are not just investing in the market by sending consultants to (inaudible) training. Just subsequent to the quarter, Accenture, one of our platinum-level partners, acquired a smaller partner whose business was built entirely on Pegasystems. This demonstrates how serious an investment partners like Accenture are making in our business.

Our integration work with Chordiant is sufficiently complete that it is impossible to talk about Chordiant versus Pegasystems deals. With one marketing organization, one management team and a salesforce that is integrated in the vast majority of our geographies, the pipeline deal flow and license signings are largely due to the combined team. So other than maintenance revenue, very little license revenue can be directly attributed to the Chordiant organization that we acquired back in April. Lastly, we had no 10% customers in the quarter.

Maintenance revenue was $26.1 million on a non-GAAP basis in Q3, more than double what it was in Q3 last year. $6.7 million of the $13.6 million increase is due to the amortization of deferred maintenance agreements acquired from Chordiant, while the balance of the increase, almost $7 million, is due to the continued growth in our customer installed base. Just about all of our customers subscribe to and renew annual maintenance agreements.

Purchase accounting rules give a haircut to maintenance arrangements that are in deferred revenue at the time of acquisition, so we have provided supplementary information on non-GAAP revenues in order to follow maintenance revenue run rates.

Professional Services revenues of $32.8 million on a non-GAAP basis are down by about $1 million from Q2. Q3 is historically a down revenue quarter for Professional Services due to lower utilization rates in the summer. This is a well-established trend. Service revenue was down from Q2 to Q3 in 2009 as well as in 2008. Professional Service revenues tend to trail new licenses signings, and are therefore expected to increase in Q4 in spite of the fact that a growing portion of implementation work is being done by partners.

Demand from customers and partners for training is especially high. Training revenues are up 79% for the first nine months of the year in comparison to last year.

Through three quarters, gross margins are about the same they were last year, other than the much larger cost of license in our GAAP financial statement. This is due to the amortization of the software intangible asset created as part of purchase accounting. This charge is added back as part of the GAAP to non-GAAP reconciliation. Page 24 of our 10-Q details the amortization of intangible assets.

As I noted, Professional Service revenues tend to be lower in Q3 than in Q2. The revenue falloff on Q3 suppresses gross margins in the quarter to the lowest point in the year before the revenue and gross margin improves in Q4.

On a non-GAAP basis, total operating expenses for the quarter, other than the acquisition restructuring charges, was $50.2 million, an increase of only $2.2 million from Q2. This is the smallest quarterly increase this year. We continued to increase headcount in the quarter, but at a much lower rate than in Q1 or Q2.

In addition to greater headcount costs, we had higher commissions associated with higher bookings. These increases were partially offset by cost reductions from the conclusion of many transitional roles associated with the Chordiant acquisition.

Sales and marketing expenses made up most of the quarterly increase in operating expenses. In Q3, sales and marketing headcount increased by 11, all of which were in the sales organization. The increased headcount and commissioning expenses were partially offset by a quarterly decrease in marketing expense. Q2 marketing expenses were higher than Q3, as they included the cost of PegaWORLD, our annual user conference.

As I said in last quarter's call, we will continue to expand our sales organization, but at a reduced rate. Our plan was to do more hiring in the first half of the year and less during the second half of the year, when we want our sales force focused on closing deals, with less time for hiring, onboarding and training.

During Q3, we added 21 people to our R&D organization, the majority of which were located in India. We will continue to invest in R&D to lengthen our lead over possible competitors and make improvements in the product that will drive license revenue growth.

G&A expenses decreased from Q2, primarily as a result of reduced headcount. During Q3, all of the transitional roles from the Chordiant acquisition ended.

Our FAS 123(R)'s charge for stock-based compensation was about $1.6 million on a pretax basis in the quarter. Note 11 to the financial statements details how this charge is allocated to cost of revenue and operating expenses. This charge is also shown as an adjustment on our GAAP to non-GAAP reconciliation that can be found on our earnings press release.

This quarter, foreign exchange rates reversed themselves and we recorded an FX gain of $1.5 million. On a year-to-date basis, we still have a loss of $4.1 million. At our normal tax rate, this loss represents about $0.07 per share to our EPS. Translation gains and losses do not reflect any fundamental change in our business condition, and they are beyond our ability to control or forecast. We are, however, making legal, tax and operational changes to move FX gains and losses from the P&L to comprehensive income so as not to impact EPS.

Other income includes $572,000 of gain on warrants that we held in a private company that was acquired.

Our GAAP income tax provision looks a little strange. On a GAAP basis, we show a loss for the first three quarters, but we have a tax provision that increases the loss. This is yet another anomaly of new purchase accounting rules, where certain items are now expensed for GAAP purposes but are not deductible for tax purposes. Our non-GAAP provision of approximately 33% looks more normal, and is a good rate to use for non-GAAP modeling.

During the quarter, we refined our calculation of the net operating losses of Chordiant that we can use in the future to offset taxable income. We have calculated that $146 million of Chordiant losses can be used, but with annual usage limitations. This refinement resulted in us recording $51.1 million of deferred tax assets in Q3.

On a non-GAAP basis, our net income of $9.8 million is a 46% improvement over Q3 2009. Basic EPS on a non-GAAP basis was $0.27 for Q3, representing half of our year-to-date basic non-GAAP EPS of $0.54, another indicator of how backend-loaded 2010 is.

Our accounts receivable balance increased by $10 million from $65.9 million at the end of Q2 to $75.9 million at the end of Q3. This increase is primarily due to greater new license signings in Q3. Our DSOs increased to about 60 days since some large payments landed in October. In fact, in the first four weeks of October, we collected approximately $40 million in cash, representing about 60% of the September AR balance.

During the quarter, we purchased 115,610 shares for $2.7 million at an average price of $23.28. At September 30, we had a balance remaining of approximately $9.8 million available for future repurchases. However, subsequent to the quarter-end at our November Board meeting, the directors voted to increase the balance available to repurchase our commons stock to $15 million and extended the buyback period to December 31, 2011.

Deferred revenue of $48.8 million was down by about $5 million from $53.8 million at the end of Q2. The largest reduction was in deferred maintenance revenue, which normally decreases during the year as the balance is amortized in maintenance revenue.

Q3 proved to be another record quarter for the Company. We ended the quarter with a very strong pipeline, which we believe will allow us to continue to grow market share. As a result, we expect more revenue records in Q4 and continued growth in 2011.

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

Thank you, Craig. Good morning, everyone. The third quarter of 2010 was remarkable for a number of reasons. We achieved our highest quarterly revenue in history. We posted our 13th consecutive quarter of revenue growth. And we climbed to number eight on Fortune's 2010 List of Fastest-Growing Companies.

But what we are most proud of is the successes with clients and the wins we've achieved as we expanded presence and brought on new customers. Since our last earnings release, Forrester has shown us as the leader in the BPM Wave Report, and Gartner has shown us as the pretty clear leader in their BPMS Magic Quadrant. To actually see these beautiful pictures, come to our website and download the reports. Very exciting, and I think reflects the strength and the investment that Pega has as we continue to push the envelope in this market.

Before I go into some highlights of our wins and [go loss], I want to talk a little bit about BPM leadership, how it is attained and recap a bit of our strategy for this year. As we've grown our company from the $100 million total revenue in 2005 to $95 million in non-GAAP for just this quarter, we've seen a lot of things change, including the definition of what BPM is and how the competitive situation and landscape evolves.

Large stack vendors have in many cases latched onto BPM, in some cases buying, and other smaller vendors have faded, frankly, because I think that they have not had the right combination of innovation and customer success to really build a sustainable business, which has been our focus all along.

What I will tell you is that even as you see the large stack vendors continue to push in this space, their sort of stack-up middleware orientation is very, very different in how they attack the problem, how they describe what they are doing, and, well, how they get results for customers. And we expect that we are going to be able to continue to be highly innovative and continue to differentiate ourselves in the minds of our clients.

We think that the key factors that have set us apart is this commitment to highly innovative technology, the ability to deliver it, and our dedication to customer success. We have continued to push in both directions relentlessly. Pega clients are furthering their efforts to become more customer-centric and are really using our technology as the way that they deliver best service to their customers, whether it is in a contact center, a claims management operation, transaction processing or even collections.

The way that customer-centricity manifests itself is actually pretty interesting. Our customers are able to accelerate the requirements-gathering process by doing what we call DCO, directly capturing objectives, right into our software, dramatically reducing time to market and the costs and errors often associated with the lengthy stage of the software development process called requirements gathering.

By using our technology right up front, by being able to generate the documentation out of our technology, we are able to really make it so that clients can see what they are going to get, and that has been responsible for the numerous 90-day implementation cycles that our customers talk about when they come to our PegaWORLD conference.

Then we leverage our rules-based process management platform to be able to execute situationally, to be able to make sure that what the customers have captured handled the unique needs, the product needs, the geographical needs, the multichannel needs, of their clients. This situational execution has been a very, very important part. We often talk about what we call the layer cake that allow customers to define what they want to be different for their customers, without having to make laborious changes throughout their implementations.

And then finally, ultimately, at the end of the day, we think that this is really about automating work, making what the system does both more personal and more efficient -- getting rid of unnecessary steps, eliminating expensive resources. And that has enabled us to be successful both in difficult economies and when economies are growing in the last five years.

So by giving our clients a chance to distinguish themselves in their markets, by making ourselves really the hub of how they are customer-centric, we have a message that we see resonating with clients and that we can continue to build on, both in terms of our core product and by adding on top of it with some of the framework assets that make the realization of these capabilities just way more accessible and easy to use for our customers.

Briefly recapping the strategy for the year, in 2009, we, like everybody else, were very, very concerned about the economy. And despite the fact that, obviously for us, it was a year of consecutive record quarters, we were pretty cautious in hiring, particularly in sales. And that, coupled with massive overperformance in 2009, which had really, really terrific results, has made for some pretty tough compares.

To make sure, though, that we were setting ourselves up to do well in 2010, but also really have strong growth in 2011 and beyond, we decided and we spoke about openly on the conference calls going into 2010 to really build up, particularly in the first half, the sales force and some of the other related areas. We wanted to deepen the penetration in our established accounts, going deeper into the Fortune 100, Fortune 200. We wanted to add new sales and frameworks teams to target markets, things like telecom and life sciences and manufacturing with our warranty framework, and horizontal frameworks like collections that could be applicable in a variety of industries.

We wanted to support new deployment models, like the cloud, being able to make it so that we could actually offer Pega in conjunction with Amazon and the elastic computer cloud environment in that sort of environment. Because we are actually very well-suited to it, since our development environment actually runs out of a browser, which is one of the things you really need to be cloud-competent.

And we also wanted to go into new geographies. We wanted to broaden our reach across Europe, for example, moving into Italy and beginning to cover other countries more deeply, deepening our presence in Asia. And we have actually continued to increase in Singapore and Hong Kong and across Australia. And opening up Japan, where we've actually launched a set of efforts and have a managing director, are actually starting to do our first paid engagements there, which for us is very exciting.

But I will tell you that I think we've executed well across all of these strategies, and we think it is a good harbinger for what we see going forward. We've been able to hire a tremendous amount of talent, we've been able, I believe, to integrate it well and we are seeing, as I will talk about the wins, the new frameworks and some of the new capabilities and some of the new sales people beginning to post returns.

So let me highlight some of the wins and customer successes in the third quarter. In Europe, we were able to extend the use of our case management capabilities with a large UK government division wanting to leverage BPM to manage cases within its own compliance department. This customer has now over 25,000 users across the organization in Pega technology. And I will tell you that closing this sort of business after the austerity program was put in recently is exactly a good example of our customers, our existing customers, see tremendous value and want to extend their footprint, even when times are difficult and tough.

One of the world's largest banks based here in the US signed another major deal to upgrade their treasury investigations and customer service, upgrading from some of our older technology they had been using for years. One of the things we are very, very proud of is how we've been able to bring our customers along across four complete generations of our technology since we started the business.

We also won another major deal in a large US bank that is going to use our decision management technology to drive better customer service and outcomes across multiple channels across the retail bank. Customer service reps, ATMs, branches, the bank's website and mobile devices and even e-mail will all benefit from this introduction of advance decisioning.

In Australia, a leading bank selected us to help with financial climate management, leveraging our case management frameworks that we offer to support anti-money-laundering activities.

In government, we achieved our first ever state government win in the area of grants management, helping to fulfill and manage the lifecycle of grants, including the application process, contracting, payments, et cetera. We are actually very excited that as austerity becomes important in a lot of the state and local governments, that this area will prove to be good, because frankly, our technology is good at saving money.

In healthcare, we won a major new-name account as one of the largest healthcare payor organizations plans to use our technology across a broad set of departments, including the contact center, claims processing and provider contracting. This is another example of giving business users the ability to take more control of their processes and manage rules that drive their business.

In telecom, we won a new-name account in Europe with a customer that will be using our decisioning solutions to present offers in the sales channel, taking into account the real-time context of a conversation. We're also going to support other customer-facing channels with personal service tailored to each situation.

We also at another telecom customer sold our first framework in the area of collections. This is a newly-developed framework that leverages both the decisioning technology that we got from Chordiant and also the BPM PRPC technology. And this combination really can bring both accuracy responsiveness and control to complicated processes such as these.

And, you know, I would say across the board, across the industries, into the cloud, where we now have more than a dozen of our clients using our technology, we really saw excellent, excellent results across the first nine months of the year.

Go-lives are, to my mind, though, the ultimate test of customers not just buying but being able to get results. And the successes there were numerous. We are expecting that when we have our PegaWORLD in the second quarter of next year that we are going to have a record number of customers clamoring to come and speak.

A large global insurance company completed their first notice of loss system using our customer process management technology in our insurance framework. That is going to enable them to more rapidly handle claims, as well as enable straight-through processing in some cases and do a better job of tracking fraud.

The retirement division of a global bank began building out a servicing backbone that will eventually provide the division with a one-stop service management shop for all matters related to servicing 401(k) customers.

Another go-live happened with IBM Global Services, who worked with us to build a new claims adjudication system for a large US federal government regulatory group. And also, the Federal Reserve themselves went live with a new case management exception processing system. Given the volume of cases managed by this customer, PRPC was uniquely suited to meet both the robust case management requirements and ensure proper agility, accuracy, efficiency and scale.

So we are happy across the board with the way this is going. I will also tell you that the Chordiant acquisition that closed in April of this year has continued to progress extremely well. We are really pleased with the talent. The engagement with the Chordiant customers has been excellent. We've found numerous situations where the synergies between the traditional Chordiant products and the Pega technology makes a lot of sense for those clients. And it has really helped deepen us in a number of key industries, such as telecommunications, and we continue to believe that this is going to be unified into a Pega that is the best of both worlds for our customers and for our investors.

[Growth] partners, which we also had talked about earlier in the year as being extremely strategic, we are very, very satisfied. We were able in Q3 2010 to surpass our partner pipeline and enablement targets for the years. We now have over 3500 partners staffed in the partner ecosystem; over 1000 have been certified just so far this year.

In addition, at SIBOS, a major international financial services trade show with well over 7000 or 8000 bankers that was held this year in Amsterdam, we had both Accenture and Capgemini announcing products built on Pega technology. Accenture announced a corporate banking portal and Capgemini announced a Know Your Customer, KYC, framework for the financial services industry.

This complements some of the successes we had in Q2, where a major provider of insurance services to the German-speaking market actually has built and we've already sold a framework that really leverages their historical expertise with our process management and rules.

So we continue to believe that this partner ecosystem is going to be a very, very important way for us to get leverage as we grow the business going into next year. And the fact that companies as such as Accenture are willing to invest in building and buying Pega expertise, I think also is an exciting affirmation of the potential the partners, the large partners see in doing work with Pegasystems.

So in conclusion, Q3 was outstanding. We are continuing to push very, very hard in both the dimensions of product, sales, customer success, and making sure that we are living up and working diligently to achieve the potential that we think is possible in this market.

We continue to take a customer-centric approach, as our customers do. And the world's leading organizations are continuing to trust us now go in new industries and new geographies, I think creating a path for good future success.

With that, let me open it up for any questions that there might be.

(Operator Instructions) Richard Davis, Canaccord.

Thanks very much. It sounds like Chordiant, under your help and guidance and stuff, has started to maybe not sprint, but at least gallop or trot forward. Is that a fair assessment?

And then the second, more derivative question would be, look, I mean they had long-standing customer base, but it would seem to me that you guys can upsell and cross-sell additional either features and functionality and/or expand within their customer base that they have. Because that is what I am just trying to -- and I know it is now part of the whole team, but I'm just trying to kind of notionally think about the growth opportunities that you get out of that acquisition.

Yes, I think you are correct in both dimensions of the, in particular, decisioning products and decisioning expertise has already complemented what Pega traditionally offered. As I mentioned, we've actually closed business in a whole new area, collections, that brings together both process and decisioning in a really good way.

I also will tell you, having met now with several dozen major Chordiant clients, there is a lot of energy and excitement about being able to use the Pega BPM technology to really help in everything from the call center to improving the way that marketing works, which is another area that Chordiant had a lot of expertise.

So we had thought that there would be really, really good client-related synergies, that there would be a chance to upsell and revitalize some of those relationships, and we are seeing that is definitely going to be true.

Got it. And I understand on a quarterly basis, services margins move around. But on a full-year basis, how do you think about that business? Should that be a -- is that a 10% margin business? Is it a 30%? Is it somewhere in between? How do you -- everyone has their own opinion on how you should run those things, and so I was just curious what your thoughts are in terms of how you think about that side of the equation.

Is definitely not a 30% business. We look at -- the primary function of Professional Services is to make customer implementations successful. Because successful customer implementations lead to radiation in the account. Historically, 75% of our revenue comes from existing accounts.

So we are willing to have a lower Professional Services margin in order to make customers successful, to enable customers. And often times on engagements, we are working with partners. And we take the time to enable the partner so that they are able to go off on their own and be successful as well.

So, worrying about whether Professional Services is 15% or 12% doesn't mean a lot if it can drive more licensed revenue, which is essentially 100% margin. And that is really how we are thinking about the business.

Historically, it has always been down in Q3. As I say, in the summer, utilization rates go way down, especially in Europe. So in 2008, 2009 and this year, revenue went down from Q2 to Q3, but you still have the same number of guys, most of them. A lot of them are on vacation in Europe, so that does hurt margins in Q3 and it has always been the case.

Got it. That's helpful. Thanks very much.

Laura Lederman, William Blair.

Good morning, thank you for taking my questions, a few. One, can you talk about this year there have been no whales, which is interesting. Some thoughts as to are there now ones in the pipeline for Q4 and also for next year? And also separately, competitive update, obviously. With Savvion being bought and Lombardi being bought and Oracle making noises in the market as well, can you talk a little bit about any changes you are seeing in the competitive environment? And then I have one final one. Thank you.

Sure. There are actually a whole bunch of whales in the pipeline. I've got a mixed feeling about whales. I think as a business, we don't want to depend on them, though certainly we got some in 2009 and we love them dearly.

I am actually quite happy to do smaller sales that preserve the value equation between us and the client, and make it so that we have the potential for more of the long-term, and the client is making sure they get value from what they buy.

But the nature of this business and the nature of our size is a couple of whales can change the quarter, which is frankly why we don't obsess that much about the quarter-to-quarter results, because it can be impacted either by a whale coming or by a decision with a client to do a term license as opposed to a perpetual license. Obviously, we think the term model is just fine as well.

So I think you need to think of this in terms of the sort of more global -- more global context there.

And a second update with competition and what changes you've seen since the acquisition of Lombardi and Savvion.

Yes, so it is actually pretty interesting. I don't believe any of -- or certainly not very many of our large customers really believe that they are going to get leading edge innovation and thought leadership out of what I sometimes refer to as the bone collectors, the companies that sort of scoop up damaged companies. And they have a long history of not really getting very innovative stuff.

So if you actually take a look at some of the campaigns, some of the campaigns to clients, take a look at some of what Oracle does, it is really based around fear. Be scared of buying things unless you buy them all from us.

I actually believe that given that most customers think that the sector that we are in is a sector that innovation still matters in and is a sector that is extremely important to their customers, it is about how they actually serve their customers and how they differentiate in the market, that over time, we will see that these stack vendors, though always being in the mix, are going to be seen by the client as not being able to provide adequate innovation. And we actually are and do see that.

So I was actually thrilled these companies got bought. Though the reality is that you see the stack vendors always, we are just now not also seeing the sort of scrappy innovative vendors; we would have seen the stack vendors anyway. Basically now, I think we've really consolidated the market in a way that will be long-term favorable for us.

One for you, Craig, which is sales headcount, either where we stand today and where we stood a year ago, or the percentage increase, so we can get a sense of standing here today versus a year ago, how much the sales headcount has increased, which helps us, obviously, understand revenue opportunities.

The details on sales and marketing headcount is compared year-over-year in the Q. Most of the increase throughout this year has been in the sales organization. As I said, 11 additional heads came on board in Q3, and all of them were in the sales organization.

Something I pointed out last quarter on the call was that the actual account execs -- and this was at June, June-over-June, we were up 58%, but a very small proportion had actually been on board here for an extended period of time, where they could be expected to be fully productive. There's a long ramp time to bring somebody on board, get them sufficiently trained, assign them to their accounts and have them start building pipeline.

Thank you. I will follow up later in the queue.

Nathan Schneiderman, Roth Capital.

Thanks for taking my questions. I wanted to begin just on your guidance view for the year. Last quarter, your guidance was $360 million of revenue and $1.02 of pro forma diluted EPS. How comfortable -- is that still your guidance, and how comfortable are you with that at this point?

Well, it's the Company's policy to issue annual guidance and not quarterly guidance and to not comment on it throughout the year. This year was a bit of an exception. Because of the Chordiant acquisition last quarter, we had to give updated guidance, primarily to have people understand that the GAAP guidance was really going to non-GAAP guidance.

So our business, as Alan said, can be extreme -- or maybe I said it this time -- can be extremely lumpy as clients make the decision to go from term to perpetual or perpetual to term when they engage with us. So we tend not to give quarterly guidance and we tend to take a much longer view of the business.

I guess I didn't understand your answer to my question. Are you still comfortable with the $360 million and $1.02, or not necessarily?

As I said, we tend not to comment on guidance throughout the year.

Okay. All right. Let me ask the question this way. Is there anything one-time in the expense structure for Q3 that will not recur in Q4, either in cost of revenues or in the operating expense? Or would you expect all of those to have seasonal sequential increases?

No, the anomalies that were in the cost structure due to the Chordiant acquisition in terms of people in transitional roles, that has pretty much ended. So there shouldn't be anything special in Q4, although Q4 is traditionally our highest bookings quarter in the year, and that therefore drives the highest commission expense in the quarter.

Okay. The 10-Q referenced a big deal in the year-ago period. Could you share with us the dollar value of that deal? And what was the dollar value of the biggest deal this Q3 2010?

Last year, we had -- it's hard to remember the exact timing of it, but we had some business that was materially over $10 million in size. And the deals this year have been more modest.

There is nothing over $10 million so far this year.

Brian Murphy, Sidoti & Company.

Thanks for taking my question. Alan, you mentioned the headcount in your partner ecosystem was in the vicinity of 3500. Just curious -- where was that number last year?

It is interesting, depending on how you count it. So we have upped our expectations of our partners' training, et cetera. I would say that the overall partner ecosystem so far this year has grown very materially. At our premier partners, it is probably up a good 30%, I would say, over the last year, and is increasing in speed.

You mentioned (multiple speakers) --

There are a lot of good indicators. If you went to PegaWORLD, you saw the level of participation by partners. If you look at our training revenue, a lot of that is driven by partners coming to training. And as we said, Accenture just bought a smaller partner who is 100% focused on Pega.

And, Alan, you mentioned that you had a go-live with IBM Global Services. I'm curious to know if your relationship with the Services group is changing at all or whether you expect it to change as the Product Group makes more of a push into BPM?

You know, I think the relationship with IBM has always been a little schizophrenic, and I am expecting that to continue. We actually are big users of the IBM stack. We actually own a mainframe, of all things, and have been for a long time. The Software Group there, can I think -- sometimes do things that aren't actually in IBM's long-term interest, because when we actually sell a system, we often move a lot of IBM gear.

The Global Services organization and individual salespeople at IBM, we, I think, have overall a very good relationship with, but it's episodic. It is kind of sometimes it's good and sometimes it's not.

The reality is, though, that some of the IBM initiatives fit beautifully, both in the area of process automation and in the area of decision management, and we are continuing to invest in that relationship and spend time, and we've gotten payback and I think will get payback going forward as well.

Thanks. I'll get back in the queue.

Raghavan Sarathy, Dougherty & Company.

Thanks for taking my questions. First, on the new sales guys that you hired, you have been ramping up your account execs starting late last year. I was wondering if you could share with us the progress these guys are making in terms of closing deals. I know it takes them six to nine months. Can you give us any color on how you feel about the progress and the productivity from these guys if you look out to next year?

Well, one measure is the pipeline, and the pipeline at the end of Q3 is -- I am looking at the pipeline at the end of every quarter going back to 2009 -- it is by far the highest that it has been.

Which is one indicator that they are generating pipeline. We've also had a couple of them actually close some business; in some cases, some pretty significant business. So I am encouraged by the talent that we've brought on. And we've invested a lot of just energy and time, training them and cross-training some of the Chordiant people that came on as well, and our staff in some of their technology. But we are feeling good about the salesforce and where it is going to end up.

Okay. And then in terms of license signings, actually, two questions. Craig, can you give us some color on the year-on-year growth on license signings? Also, I notice in your Q, when you discuss subscription revenue, it declined year on year due to change in customer selection of renewal option. And I was wondering did the customers select perpetual or term when it came for renewal? Can you help us understand this?

I could actually -- I think I could answer some of those as well. I think that this year suffered a bit from being a tough compare and the fact that if you go back and look at 2009, we really did not increase the salesforce very materially in 2009. So that is something we took aggressive steps to remedy as we entered -- toward the very end of last year and as we entered this year.

That, coupled with some of the 2000 whales, leads to a tough compare. But we are still very optimistic about what we are going to be able to get done when we announce the year as a whole, even compared to 2009.

Relative to customer renewals, we have lots of deals that go all sorts of ways. We have customers that sometimes will flip and have a new piece of business be a term deal instead of a perpetual. And we do have customers who come to the conclusion of a term arrangement and want to change it, and depending on the circumstances, we will do what makes sense in general. So you will see those sorts of things happen fairly routinely. And I don't actually take think it is very material on individual clients.

One final question. There was $2.6 million adjustment to GAAP license revenues. I know this is related to the purchase accounting. Was it all applied to the perpetual license or split across the three license lines?

I believe it was perpetual. Chordiant didn't do a lot in the way of term licenses, though. I believe it was perpetual license that was in deferred revenue at the time of the acquisition. So the GAAP rules are that we took a big haircut on it.

Okay, thank you. I will jump back in the queue.

Steve Koenig, Longbow Research.

Thanks for taking my questions. I would like to just follow up on the question about the licenses. I understand they do move around a lot quarter by quarter, as customers may select different renewal options.

When I look at the subscription line, though, the falloff sequentially of about $3 million is the majority of your subscription revenue. On an annualized basis, that is $12 million a year. And if, for example, that represented a customer moving to a perpetual license which was booked in the quarter, that would be a very significant piece of revenue. So I am wondering if you can comment on specifically why subscriptions were down so hard sequentially, and how should we expect subscriptions to trend going forward?

Subscriptions are hard to predict because people get confused. They think subscription is Software as a Service. It's not. It's just an accounting methodology. And one of the aspects of that methodology is that you take subscription revenue up until there is a customer payment. And if there are staggered customer payments, oftentimes what happens is that in a quarter, your subscription revenue dries up on an account until they have a big scheduled payment next quarter and it jumps back up.

So they do bounce around a little bit. It's not the case that somebody switched from a subscription to a perpetual. In actual fact, the subscription revenue is a perpetual license. It's just a methodology in terms of revenue recognition. It is not Software as a Service.

Okay. So in this case, it wasn't a case of a subscription customer, you having booked that revenue as a one-time due to some kind of switch in accounting. It is more a cash payment issue?

Yes, because you take subscription -- you may have a customer that pays you -- I'll make up some numbers -- $5 million every other quarter or something towards their perpetual, and that all of a sudden one quarter, can't take more subscription than what they paid. So you could run into a little dry spell for a couple months and then a payment is due and then you have a catch-up.

Okay, so in that case, how should we think on a normalized basis about kind of the level of subscription revenue or the mix of subscription revenue for Pega on a more normalized basis?

It's actually pretty minimal. We don't enter into those agreements very often. They are fairly unique. And it is not -- we prefer to keep people on a straight perpetual or a straight term license. It is very rare that we get into the subscription accounting.

Okay. And then lastly, this is probably another one for you, Craig. We had modeled and hoped perhaps DSOs would be down a little bit more following -- after a quarter of Chordiant being in there. I remember you mentioned you had some good collections in the start of Q4 here.

How should we think about DSOs trending? And then more generally, how should we think about operating cash flow? When should it turn positive? Should it be positive in Q4, should it be positive for the year? Any thoughts on how we can think about cash flow would be helpful, too.

Sure. So, first of all, DSOs are up because we had quite a few very strong bookings at the very end of the quarter, so they go directly into accounts receivable. And a lot of times that is what drives up the number.

It just seemed -- and I don't know why -- that we had a lot of payments just miss the quarter and fall into October. As I pointed out, in the first few weeks of October, we collected $40 million, which is a vast majority of the receivables balance. So to take a snapshot of any one time is a little bit misleading.

With regard to the cash flow, the cash flow from operations this quarter was hurt because we booked a lot of deals and they're sitting in receiveables. You can say that on the Statement of Changes.

During the first half of the year, of course, cash flow was impacted by the acquisition and all the acquisition expenses that go along with it. So I think in Q4, you'll see us turn the corner.

Okay, great. Thanks a lot, guys.

Martin [Schulz] of HIRG.

This is Martin of HIRG. Prior to its acquisition, Chordiant had about $40 million of contractual backlog. How much of that is factored into the aggregate term license value that you reported? I know you said not much of their business is term. But how much of that is in your off-balance sheet numbers? Thank you.

Most of their backlog was maintenance agreements that they held. They had a practice of signing multi-year maintenance agreements, which is something that we don't do, and that constituted a lot of their backlog.

When you do purchase accounting, of course, you take a haircut on that, and that's what you'll in the GAAP to non-GAAP reconciliation.

Okay.

But I don't think there were any Chordiant term deals. If the question is specifically about term, that wasn't a model that they used.

No, they didn't do many term deals at all. In fact, I can't --

So the acquired contractual backlog doesn't roll into your reported metrics, essentially, in any way?

No.

Okay.

No, those are all our deals.

Thank you.

Edward Hemmelgarn of Shaker Investments.

You had the one Chordiant Software deal that you had $2.6 million of the -- under normal circumstances, your revenue would have been higher by that amount. How much of that was in -- was actually recognized and was in deferred revenue as license revenues because of the acquisition, the purchase price allocation?

I'm sorry, Edward, could you repeat --?

In other words, you had a deal that was in deferred revenue, in effect. I mean, when you bought Chordiant, it was -- under ordinary circumstances it was going to be recognized this quarter, but when you accounted for it in the purchase price allocation you took a haircut of $2.6 million. Obviously, some of it was still in license revenue or deferred license revenue. I mean you account for some of it, I am assuming.

And of the $17 million plus of the purchase price allocation that you put into deferred revenue, how much of that was deferred license revenue as opposed to deferred maintenance or deferred service?

Most of it was deferred maintenance. There was a couple license deals, and you're right, you're picking up that $2.6 million on the GAAP to non-GAAP adjustment. So there was a perpetual license deal in there. There was very little deferred service. I think it was probably only about a couple million dollars. And as you look on the GAAP to non-GAAP, you'll see there is very little add-back there.

But the majority of that was maintenance, right?

Yes, most of it (multiple speakers).

I understand it was -- I'm just try to get an idea -- was it $1 million in deferred license revenue, or was it $500,000, was it $2.5 million? What were we talking about?

You could probably think about -- I don't know the exact details of that deal, because you had to value each deal, but generally take a haircut of almost 50% on some of these things.

Okay. Then Alan, can you talk a little bit about new customers, in terms of you've added dramatically to the salesforce, obviously. What percentage of orders that you are getting in now are coming from new customers relative to existing customers? And -- not in terms of the dollar amount, but just in terms of new customers, can you talk a little bit more about that?

Let me see if I can find the actual numbers here. But this early, I would say that it has gone up, which is unsurprising. And it is definitely well over a third of the bookings, I would say, are related -- or the relationships are related to new clients this year. It is up quite significantly from last year.

Yes, the number of accounts is up almost fivefold. Typically though with new accounts -- and I say typically, because there are exceptions -- a lot of times with new accounts, the deals are smaller to start with. People, we tend to try and sell them a smaller sliver, something that could be delivered quickly and successfully and they can see the value on that initial transaction, which helps us establish ourselves with that account.

But that's -- the number of new customers is a function of -- a lot of it is a function of new salespeople covering new accounts and new geographies, and new partners as well. Partners tend to bring us new customers.

I guess I'm just trying to get at somewhat, obviously, it's with the new customers. But in terms of all these new salespeople you've added, is it you're -- there is always a lag, and some of it is just getting the first order. But as you've described it, they tend to be -- or at least your experience is they tend to be smaller at first.

So is -- when you would really expect to see the impact of the new salesforce hires in 2011 and 2012 as opposed to this year?

Well, we knew we were going to see it primarily in 2011. If the sales guys that we're hiring in 2010 aren't nicely productive in 2011, shame on us. I mean, that should be more than -- that should more than adequate time, I would say.

So I'm actually just looking at some things that Craig has pulled up. And in fact, the new customer deals are very a meaningful percentage here of what we are signing, and we think that is exactly as it should be. We've actually been very excited about being able to put these new names on. And given that we don't sell out our customers, but really look to have long-term, mutually beneficial relationships with them, getting into a new customer and doing a good job for them is money in the bank and good service for them.

(Operator Instructions) Gregg Speicher of 451 Group.

In this record-setting pipeline you have, can you tell us is it trending to licenses or term, or can you give us some feelings there?

I don't think the proportions are particularly changing. Sometimes, those decisions are not made actually until quite late in the decision process, and we'll go back and forth with a client.

But this really -- so when we put it in, we don't obsess, when we label the opportunity, about whether it is going to end up being a term or end up being a perpetual, because, as I said, they will often flip back and forth. Sometimes our clients find that their capital budget approvals are much harder to achieve than just ongoing operating expense, and that is the kind of a trade-off between license and term.

But I haven't sensed any particular change over the last 12 months.

So there is no theme among all these new customers you are signing? They are not -- they don't tend to go one way or the other for whatever a trend or a new thought might be?

No, it is very much the same sort of mix that we've seen with the traditional customers.

And it's extremely unpredictable. Last year, when the economy was bad, everybody was predicting we would swing towards more terms, and it just didn't happen. So I've given up trying to predict it.

My other question is related around call centers. What percentage of your newer bookings and pipeline are around either replacing old call-center systems or augmenting or decisioning or that type of deal?

So it's actually -- that is way up. And we are doing both a lot more call-center work and a lot more what I will call multichannel work, where the customer actually uses us not just in the call center, but to be able handle service in, for example, the web or in the voice response unit or in a branch facility as well.

So things that I would describe as being part of front office customer service is very, very significantly up. I would say that at this point, a good 50% or more of our business is either a call-center replacement, in some cases, but much more often a place where we've been woven into an existing call-center system to make it better. And by the way, many of those then lead to replacements down the road as we sort of hollow out their existing environments.

So call center is going to be very significant for us, I think, going into next year.

Okay, perfect. Thank you.

Raghavan Sarathy, Dougherty & Company.

Already answered. Thank you.

Brian Murphy, Sidoti & Company.

I just have one quick follow-up. Alan, you mentioned the tough comps, the tough license bookings comps in 2009, and sort of the outperformance that you guys had in 2009. Just looking back now at that bookings environment in 2009, was there anything unusual about that environment? Or do you think that you can get back to that level of salesforce productivity?

With the benefit of hindsight, the thing that I think was unusual was despite the fact that our license revenue increased about 50% in 2008, we choked back on hiring in the first half of 2009, which I think had a pretty direct impact on our 2010 performance. That, coupled with the couple of whales, is the thing that is unusual.

As I said when I went into this year, we decided we are going to work to rectify that, and that has been the basis for -- I think you cited a 58% number of growth in terms of sales and marketing headcount.

So the thing that was perhaps unusual, though rational, was we read the papers and decided that we would slow the hiring down in the first half. With the full benefit of hindsight, I wish we hadn't done that. It would have actually made this year easier.

And we are going to be very thoughtful as we go. And we're right now we are in the middle of our 2011 planning. We are going to be thoughtful about thinking what we want the 2011 rollouts to be. But I believe if we continue to see really strong pipeline, if we are able to show that the new salespeople are coming online and being successful, that I do think we want to continue to grow sales and marketing, because there are a lot of really, really great uncovered accounts that could really profit from our stuff.

Got it. That makes sense. So it sounds like there was a period where there was sort of a depletion in the early stages of the pipeline, and maybe that manifested in the first half of the year here. Do you think that we've lapped that sort of hiccup in the pipeline and we should get back to sort of robust license bookings growth?

Certainly the pipeline from a year ago has grown in a way that is consistent with the sort of sales and marketing growth that we've seen. We've seen a very significant increase in the pipeline on a year-to-year basis. And if you would go back a year before, obviously, we weren't having salespeople at the same rate in the first half of 2009, so we hadn't seen that. It was much flatter.

So the numbers don't lie. I think you need to look at sales and marketing expense over a couple of years, take a look at license revenue. And I actually think the story is pretty clear.

Thanks very much.

Thank you. I am showing a further questions or comments at this time. I would like to turn the conference over to the Chief Financial Officer, Mr. Craig Dynes, for any closing remarks.

Thank you very much, everyone, for attending our call. We will look forward to talking to you again at our end of year call, which will probably be scheduled for February. And I will be out on the road and we will be talking to some of you very shortly. Thank you very much.

Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect, and have a wonderful day.