Pegasystems Inc (PEGA) 2012 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Pegasystems Inc. Q1 2012 earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions on how to participate will be given at that time. (Operator Instructions) As a reminder, today's conference is being recorded. Now I would like to turn the call over to your host, Pegasystems Chief Financial Officer, Craig Dynes.

Thank you. Good evening and welcome to the Pegasystems 2012 Q1 earnings conference call. With me here in Cambridge is Alan Trefler, Pegasystems' Founder and CEO. Before I introduce Alan I will begin with our Safe Harbor statement and then provide my financial commentary. Certain statements contained in this presentation may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words anticipates, projects, expects, plans, intends, believes, estimates, targets, forecasts, and could, and other similar expressions identify forward-looking statements which speak only 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 2012 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 are contained in the Company's press release announcing its Q1 2012 earnings. And in the Company's filings with the Securities and Exchange Commission, including its report on Form 10-K for the year ended December 31, 2011, 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.

Q1 was a solid start for the year. At $111 million of revenue it was the second-highest in our history. And bookings were strong enough that we didn't need any backlog. It is pretty normal in the enterprise software business to build backlog in the second half of the year and use backlog in the first half, so maintaining license backlog where it was following the bookings blow-up that we had in Q4 is a good start to the year. License signings were up in Q1 of last year, even though Q1 of last year is a tough compare. I say tough compare because, if you remember, license signings in Q1 2011 were up approximately 85% over Q1 2010.

Q1 also saw us close a major deal with an oil and gas producer. This is a vertical which we think holds great potential for us, so I'm pleased to see us get some traction in this market. In the quarter, the meter swung back towards perpetual licenses as compared to the large number of term deals we did in Q4. Many of the perpetual licenses had extended payments or other terms that put the deals into backlog rather than on the P&L. Page 23 of our Q details off-balance sheet backlog of signed, non-cancellable licenses. The backlog of $210.4 million increased by approximately $0.5 million from Q4, primarily due to a $7.8 million increase in perpetual licenses.

We look at our business over a time period longer than a single quarter. So when you compare the backlog of $210.4 million at the end of Q1 this year to Q1 last year, it shows in one year an increase of $93.4 million, almost an 80% growth. Our maintenance business continues to be very strong at $30.8 million for the quarter. Since Q1 of last year through Q1 of this year our renewal rate on maintenance agreements was approximately 95%. This was also a very good quarter for professional services. It has been our pattern for a few years now to see significant Q1 pro serv revenue growth following strong Q4 bookings. In addition to the revenue, it was a good quarter for services gross profits. Three larger projects ended in the quarter which drove services gross margin to 18%. Our partners continue to lead in a majority of new projects. However, the dramatic increase in Q4 bookings drove our pro serv business to higher revenue levels, where we expect to stay until the summer when consulting hours drop due to customer vacations.

Q4 bookings also pushed training revenue to its highest level in approximately two years. However, as we said in our last call, our new online training capability, Pega Academy, will roll out this year. This is a far more effective way to deliver training. We expect that with Pega Academy we will be able to faster grow the Pega ecosystem by training more customers and partners using online delivery. It is also more cost-effective training and will have a new fee structure. We think that growing the number of trained customers and partners is more viable than the reduction in training revenues we are expecting.

Operating expenses for the quarter decreased from the Q4 run rate by about $5.3 million. This is almost entirely due to a decrease in sales and marketing costs. While bookings were good in Q1 they were, as expected, less than the record Q4 bookings. The resulting decrease in commissions was partially offset by the cost of our Q1 sales kickoff meeting and an increase in headcount. During Q1 we added 25 employees to sales and marketing, of which 19 were in the sales organization. R&D headcount and costs increased slightly in Q1 from Q4 as headcount increased by eight employees. Since 2006 we have been investing heavily in R&D, as well as in sales and marketing.

In 2011 we added 87 new employees to the sales and marketing organization. In order to cover more named accounts, geographies, verticals and partners, we need to increase our sales headcount. We believe that the last six years of near 30% revenue growth are due to these investments and we plan to stay the course on this growth strategy. In Q2 we plan to further increase headcount and we will hold PegaWORLD 2012, our largest and most expensive marketing event of the year, in Dallas. The increased headcount at PegaWORLD will result in increased sales and marketing expenses in Q2. G&A expenses decreased slightly from Q4 due to reduced professional fees, even though the head count increased by four.

In order to provide normalized run rate financial information, and to allow comparisons to those building or publishing financial models, we provided supplemental information in our press release to reconcile to a non-GAAP model. Following the same format that was used when we provided guidance as part of our Q4 earnings release, there are three reconciling items. FAS-123R charges for stock-based compensation for Q1 were about $1.8 million or $0.05 per share on a post-tax basis. The amortization expenses of the intangible assets created by purchase accounting for our Chordiant acquisition was also approximately $1.8 million or $0.05 per share on an after-tax basis.

And lastly, as we explained on our Q4 call, we are in the process of moving our offices. GAAP accounting makes us accelerate depreciation and straightline the new lease cost. This results in double or overlapping non-cash rent expense for both offices, while in reality we have free rent for our new office until the old office lease term ends in a year from now. As we did in Q4, we have added back this overlapping non-cash lease expense, as well as the one-time cost of moving the offices to present a more normalized run rate model. In Q1 we recorded $1.2 million or $0.03 per share on an after-tax basis for these nonrecurring expenses associated with the office move.

The supplemental GAAP to non-GAAP reconciliation shows a non-GAAP EPS of $0.23 per share. We ended the quarter with $88 million in cash as Q1 cash flow from operations was a use of $17.8 million. This is similar to last year, as Q1 is the quarter when we pay out our annual corporate-wide bonus plan, 401(k) contribution matches, and the large Q4 sales commissions. As detailed in note 6, trade accounts receivable decreased slightly from $77.1 million at December 31 to $74.8 million at March 31. The age of these receivables dropped from 65 to 62 days. However, due to the increase in consulting volume, and some contractual payments terms on new perpetual licenses, our unbilled accounts receivable increased by more than $11 million from December 31. This increase is why, on the face of the balance sheet, total accounts receivable increased from year end.

Q2 collections are very strong. In fact, at the beginning of Q2 through today we have already collected approximately $50 million of the March 31 accounts receivable balance. During the quarter we purchased 27,383 shares for $830,000 at an average price of $30.34. At quarter end we had a balance remaining of approximately $13.1 million available for future repurchases. Deferred revenue shows up in two places on our balance sheet, short-term and long-term. The sum of the two, which is $94.2 million, is an increase of almost $5 million from the end of 2011, as a result of a sizeable increase in deferred maintenance revenue, partially offset by slight decreases in deferred license and professional services revenue.

On our 2011 Q4 conference call we gave our annual guidance. We've always given only annual guidance and followed the policy of not commenting on it through the year. We also gave guidance for the first half of the year to provide visibility into the timing of our annual results so as to provide additional milestones to chart our progress. Commenting further on this guidance would represent quarterly guidance, which is something we do not do for several reasons. First of all, we sell both term and perpetual licenses, and the mix between the two can cause quarters to be lumpy and unpredictable. The recent swing to term licenses in Q4, then back again to perpetual licenses in Q1, illustrates this fact.

Secondly, customers have annual budgets, not quarterly budgets. We are reluctant to offer large discounts to incent a customer to purchase in a particular quarter because our business model is to sell additional purpose-based licenses into our existing accounts. A big discount this quarter would set unreasonable customer expectations for the following quarters when we are selling follow-on deals. As a result, we don't manage to the quarters and so we don't give quarterly guidance. We are reluctant to even discuss any guidance during the year as we see our objective as maintaining the tremendous growth that allowed us to grow from the $100 million a year software company that we were as recently as 2005.

So while we don't give our managed quarterly numbers, I would like to point out to those building models that historically there have been quarters where revenues have not grown sequentially. In fact, in the high-growth years of both 2006 and 2007, we had down quarters during the year, but on an annual basis still put up gross numbers of approximately 30% in both years. Last year was another example. We followed a slow bookings and revenue Q3 with a bookings blowout in Q4. Lastly, our profitability for the remainder of 2011 will be somewhat back-end loaded. As I said, we will continue to invest in our sales capacity, our partner ecosystem, and our R&D team. In addition, in Q2 we will hold PegaWORLD, which is our largest and most expensive marketing event of the year.

In summary, Q1 was a solid start to the year. Our profitability was good and we maintained our license backlog. With this start and PegaWORLD in Q2, we will continue to build momentum the rest of the year. With more detail in Q1 achievements, I would now like to turn the call over to Pega's Founder and CEO, Alan Trefler.

Thank you, Craig. And good evening to those on the phone. Pega is gaining market share in the BPM -- business process management -- and CRM -- customer relationship management -- markets. It is a very exciting time. Abbreviations and tech terms can be muddy, but the power delivered by our technology is indisputable. Pega software revolutionizes how organizations serve customers and automate work by empowering business people to create and evolve their critical business systems. This produces staggering returns.

We provide the world's leading platform for organizations to unify their business applications, unifying business rules, business processes, user interface, integration with external systems. Reporting, decisioning and mobile in one architecture that can be deployed on premise, on a private cloud or on the public cloud. This is incredibly powerful and the underlying technology empowers business people to create and evolve these mission-critical business apps for customer centricity, for saving money, and for building for the future. These are really the central value propositions of BPM and CRM.

Pega enhances this core with capabilities that deliver and drive Next-Best-Action marketing automation. We also build industry-specific frameworks with preconfigured industry best practices, industry specialized rules and processes, pre-configured industry standard data models and pre-configured UI end reports. Customers enjoy the speed to market and best practices in these models and frameworks. And because our CRM products and our industry frameworks are built on our unified platform, they automatically inherit the powerful benefits of business agility, business specialization, and multi-channel work automation. All accomplished with no or little manual coding.

Our continued investment in R&D has enabled us to stay ahead of the market. And we plan to continue to invest a higher-than-average percentage of revenue in our industry-leading software as we continue to grow it, and focus on delivering customer success. We achieved our Q1 revenue plan while also increasing backlog over Q4 2011, a very good quarter for Pega. At the same time, our pipeline increased very significantly from the end of Q1 2111 to over $1.5 billion at the end of Q1 2012. And consistent with our increasing focus and relationship with our partners, 59% of our pipeline at the end of Q1 was sourced or leveraged by our partners. It is a good set of progress that we're seeing. And, as Craig said, it can be a lumpy business, but I'm very excited about where we are and where we're going.

We've had tremendous successes in CRM, winning significant business in multi-channel contact centers. Customers love the develop-once-deploy-everywhere capabilities of our technology. They can create an application and a set of processes regardless of the channel to which they want to interact with their clients. Contact center, web, voice response, mobile devices, social media, inbound, outbound. The rules and processes just work for all of them. If you're a credit card company and you want to treat your gold customers a specific way, you tell the system once how you want to deal with them, and regardless of how a gold customer interacts with you, that customers will be treated appropriately. In April, the Gartner report on CRM for customer service was published, and Pega is positioned in the leaders quadrant in that publication; a testament to our customer-centric approach and our business growth in this area.

We have been seeing tremendous wins with our Next-Best-Action marketing solution. Instead of a traditional campaign marketing approach where a company picks a product and markets the product to a group of customers, and you know how much you love seeing those brain-dead marketing messages come. With our unified marketing solution, Pega clients are able to define much more sophisticated strategies using predictive and adaptive analytics, and really taking advantage of the big data that is becoming so popular, and helping to drive better and better decision-making across channels. So, for example, if a telecommunications company does the analysis and sees high-usage customers who have a text plan for their children tend to stay about twice as long as other customers, they can execute a strategy by which these customers will be offered a special deal to help make sure that their kids become hooked on that mobile provider. This is terrific. It actually helps grow business and can massively improve retention. Just an example of how the Pega technology makes the right decisions. And then even better, when the customer accepts, we operationalize the implementation. We actually handle the order processing, the provisioning, all the things it takes to go from A to Z and really deliver the right propositions and execute brilliantly. There is nothing like it on the market.

We also had great wins in Q1 for the use of our technology in straight forward operational improvement. A global energy company selected us to dramatically improve the speed and productivity in how they respond to issues and incidents. A situation that impacts billions of dollars and can impact millions of people. We won this against the traditional stack vendors whose software could not handle the specialization for each business unit of this global company, coupled with the need to operate in many countries on a single architecture. We frequently hear that clients need the ability to specialize by business unit, by client, by jurisdiction, and only Pega has a technology designed specifically for those types of problems.

We also had a great Q1 win with a major electronics manufacturing company who selected us to ramp and renew their SAP systems for significant operational productivity improvements. This is actually very common. We have over 60% of our clients who use SAP and we find that we can add tremendous values to those clients and really get them to be much more process efficient and customer-centric, while taking advantage of the investment that they already have.

It is clear from these examples we are seeing business wins in an expanded set of industries, going beyond our traditional strong verticals of financial services, healthcare and insurance to energy, manufacturing, travel and transportation, communications, and IT services. It was a great quarter for go-lives, as well in Q1, with wonderful customers such as GM, Deutsche Bank, American Express, Express Scripts, France Telecom, INZ, Zurich Financial, Highmark and Barclays, all sorts of great clients going live with our products. It was really tremendous. So in Q1 the demand for our software was exceptional, and we are really excited as we continue the year. We think that we will continue to win the kudos of industry analysts and that we will continue to be able to wow customers with the speed and effectiveness of our technology.

We are doing things to broaden this adoption. As I've often spoken about, our partner program continues to be a source of great focus. And I'm also pleased that this quarter we will be introducing the Pega Academy, which is a major self-study style of enablement where people can take world-class lessons through video, through exercises they execute on their own machines, on their own time, and really learn our products through self-study. We think that this will reduce the cost of education by more than two-thirds. And we are seeing that you can achieve high certification and pass rates which gives us confidence that customers and prospects and partners will be able to learn well through this technology. This is exciting and we were able to launch it using our own technology and on our Pega cloud, public cloud, so it is blazingly fast.

In closing, I want to spend a moment or two talking about an event that is coming just one month from now that I think is a great way to understand what Pega is about and what we really do. And why we are so excited about our charter. In early June we will be holding our PegaWORLD 2012 conference in Dallas. We expect record attendance and have more than 75 enterprise customer and partner speakers standing up to talk about what they are doing with Pega and really telling enormous and terrific stories of achievement and of customer-centricity. One of the things that is interesting is we chose to have an outside speaker join us, as well. We decided to have Fred Reichheld, who is a noted customer experience expert and the author of a book called The Ultimate Question, which talks about how organizations can really gauge and enhance the loyalty of the customers. What I love about the book, which was actually directed at me by a customer, is that about -- more than half of the examples of excellence in service and loyalty in that book are actually Pega customers. Companies that have chosen Pega to achieve, to maintain or to extend the loyalty and the relationships with their customers. We are going to be able to hear that in spades at PegaWORLD.

We are thrilled, for example, that Jim Bush, the Head of World Service at American Express, a five-time JD Power award winner and a great Pega client, has chosen to come and is going to talk about the journey that they are on around customer excellence. United Healthcare Group is talking about how they're doing massive revisions across the organization to really improve both the quality of care and its efficiency. Other clients, like PNC Financial, which is an award-winning customer, is using us to actually do more than 1 million offers and decision requests every day to be able to optimize the way they interact with their customers. They will be talking.

Health Net is talking about how they're using us across their healthcare environment; Vodafone Germany talking about how they increased operational efficiency; GE Healthcare discussing how they're using us to do regulatory management and spend management, which is very important based on the recent healthcare laws. The state of Texas, talking about the many initiatives we have working down there. Jabil, a large manufacturer, is talking about how they're using us to get realtime process improvement across the organization. Prudential Insurance talking about how we are creating consistency across product groups. State Farm, Tenet Health, Zurich. There are so many who are willing to come and speak, that it really makes us proud and really reinforces what a great collection of customers we have the privilege to work with. And what an awesome group of partners are now increasingly driving business with us and achieving excellence with those clients.

So I will tell you we are all working hard and we are pleased that we are making progress. And with that let me open it up for questions. Thank you very much.

(Operator Instructions) Nathan Schneiderman with Roth Capital.

I was hoping we could start with, you did reference some success with bigger deals. and you called out one in oil and gas industry in particular. But I was curious if you could share with us maybe the number of deals you achieved over $10 million and maybe the number of medium-sized deals for you, $5 million to $10 million.

We had a few over the $5 million mark. And some of the deals that are biggest, actually, have some contingencies in them. So we are not actually considering them fully bookings now. But it was really exciting to sign up with one of the world's largest companies in that space. I think it's a harbinger for a lot of good things.

You had referenced a pipeline of $1.5 billion. I was just curious if you could share with us, what percentage would you say that is up year-over-year?

I think year-over-year is up about 40%, high 30%s, maybe 40%.

Okay. And final question area for you. I was just curious if you could share with us more statistics on the success you're having with the decision management product, the Next-Best recommendation engine. Curious if you could share with us maybe the number of deals you have achieved in the quarter. What percent of your licensed bookings do you feel are being driven by this particular product? Thanks very much.

Sure. I have actually had a chance to look it up and the actual number was 43% year-over-year. But the Next-Best-Action bit, it's really starting to get excellent momentum. We, over the last six months, and including in the quarter, have won a couple of very significant pieces of business where it is really a combination of Next-Best-Action powering BPM and being powered by BPM. So, it's not as easy to tease those apart. I actually think that the Next-Best-Action is probably a pretty good thing to have in the midst of most processes. What I would tell you is we're seeing it probably start to play a role in one-quarter to one-third of the deals. And I think we are going to see that number in the second half grow to 50% or more.

Laura Lederman with William Blair.

Can you talk a little bit about the contingent deal and why it's not booked, what types of things is it contingent on? And was that the big oil and gas deal? I'm just trying to understand the contingencies. And does that mean it doesn't show up anywhere, even in the exhibits in your Q that talk about future revenue recognition?

Contingent is probably the wrong word. I think it was a deal, a multi-pump deal where they buy something with a commitment to buy more. But certain things have to be achieved before they did. Anything that looks remotely like that doesn't show up in any of our numbers. We would never include something like that. But the sales effort in this case was commensurate with something that is truly whale-ish. And the team actually delivered on it and I think we are in really good shape as it goes forward. The nature of the business, though, I would just as soon not get into too many details on it.

Fair enough. Can you talk about that pipeline in terms of composition, how much of it is your traditional vertical financial services -- insurance, healthcare -- versus new verticals?

We don't split them out to that level of detail. The pipeline is still meaningfully heavier towards our traditional businesses because, frankly, they have been doing really well. Financial services, despite the economy, continues to grow, we continue to add staff. And continue to deepen the relationships with companies like JPMorgan Chase, Lloyds, American Express, and ANZ Bank. So that continues to do very well. It is still the larger part of our pipeline, I would say, would be those three traditional verticals. Fast on its heels, though, is telecommunications which has been really burgeoning forth over the last couple of quarters.

Can you talk a little bit -- final question from me -- what you're seeing in EMEA? In other words, there's always been fear of what is happening in the economy there in terms of the demand there versus the US?

The pipeline is good. It is a little scary to read the newspapers, to tell you the truth. But we are still getting the meetings, the engagement, and the bookings from our clients. And we have some very significant transformation programs that are going on. But it is difficult to predict what is going to happen in Europe. We're trying to make sure we are hedging our bets in North American and Asia at the same time.

Thank you very much.

Raghavan Sarathy, Dougherty & Company.

I think, Craig, talked about license signings with flat year-on-year against a tough comp. I was wondering if you could give us some sense that the license signings were in line with your expectations, about or at below expectations?

Actually they were up slightly in Q1 this year compared to last year. But it was a tough comp because last year in Q1 they were up 85% over the Q1 the year before. Most of our expectations are built around periods that are longer than a quarter. Q1 is a pretty small snapshot to really get too excited about one way or the other. We are more interested in our annual goals than our quarterly goals.

And you have two Q1. We have a sales kick-off. There's a lot of disruption, a lot of customers, for us anyway, we had such a staggering set of buys in Q4. Just blew the doors out. So I was actually pretty happy that we had a successful Q1 on the back of just such over-achievement in Q4.

To be honest, any time you can go through Q1 and build backlog, license backlog, that's great.

Yes, it's a little unusual for us.

So the follow-up would be, it looks like you have a tough compare coming up in the second quarter two. Where you, I think, last year second quarter licensing nearly tripled. So I was wondering whether we should have modest expectation again for the second quarter given tough compare?

Our quarters can be very lumpy. Last year is a very good example. At the midway point in the year, we probably had done more bookings towards the front end of the year than we have ever done before and then things slowed down in Q3. And then we had a monster Q4. So quarter by quarter the business is lumpy not just from financial statement revenue, but also from license signings.

Just two more questions and I'll jump off-line. It looks like you added 25 headcount in your sales and marketing. I think, Craig, you said 19 in the sales. That's compared to 13 last year same quarter. It seems like you are ahead this year in terms of hiring. I was wondering how we should think about sales capacity increase whole year and whether it's going to be front-end loaded, or the trend is going to continue.

I think we're going to continue to hire at a good pace. We are setting very aggressive targets as we think about our multi-year growth plans. And to be blunt, the people we hire in the second half of this year are going to be entirely aimed at 2013. It takes a couple of quarters for them to get trained and start to book business. So if we like the way the global economy is going, even though it is not going to affect the financials positively this year, we will hire in Q3 and Q4.

And especially if we find good guys.

And then my final question. Alan, you mentioned in the press release that you are expecting 2,000 attendees for the PegaWORLD. How does that number compare to the year before? We are thinking that attendance will probably be up something between 35% and 50%.

Okay, thank you.

Steve Koenig, Longbow Research.

I have one for Craig and then one for Alan here. Craig, I am wondering, you gave us some good color on the individual cost lines relative to the Q4 run rate. There was a large amount of EPS upside relative to the first half-second half split that you've talked about. Can you comment, can you help us understand, where did all that upside come from on the earnings line relative to your expectations?

A lot of it had to do with the mix of license revenue. That is what is a major source of lumpiness. As I pointed out, the dial swung back a little bit towards perpetual licenses, as compared to Q4 where it was significantly towards term licenses. So that always affects the profitability. We had some bigger expenditures in Q1, as well. We had our sales kickoff which was a very expensive exercising and training the sales force, but well worth it.

I think we did a better job of expense management at the sales kick-off. And then some of the others, the team worked hard and is working hard to try to make sure we are hiring as efficiently as we can.

Okay. All right. And then, Alan, one for you here. You guys have so many diverse use cases that you can address. It is impressive but also sometimes it's hard to get your arms around the totality of what you can do without addressing all the individual use cases. I was wondering if you could generalize a little bit on CRM in particular. You talked a little bit about last year's PegaWORLD, about some interesting developments on your CRM road map. I almost got the sense that it was almost an application per se, kind of Siebel killer, if you will. Or something of that ilk, to help all those accounts that are saddled with legacy systems. Can you comment on where the road map has gone in CRM? And, if possible, where you're going with that?

Sure. Our cut on CRM is we are the technology that you want when you've got a somewhat complicated business and a customer base that is demanding. And where you want to be able to provide service that cuts across the channels so that you can have somebody -- one of our European clients taking lives, loans, over the web. They're trying to solicit credit card applications and other applications for personal loans. They were expecting when they rolled it out earlier this quarter, or in the first quarter, that they would get about 70 a day. They are getting 70 an hour. And they are able to have somebody start in that channel, flip into the call center, do all of the stuff you'd like to be able to do. So that is an example of a company that previously had Siebel and is looking to wrap, renew and eventually replace it. So you can think of us as being the smart layer that makes it so the service reps don't have to go to 15 systems. We do it for them. And that allows you to plug right into the website or to Facebook and really offer that multi-channel experience. I think we are highly differentiated in the market. I think we're able to do a level of sophistication that companies really need today as they are trying to improve loyalty and make money. And it fits beautifully with the Next-Best-Action and the core BPM technology around operationalizing things. So I think it's a great story.

Great, thanks a lot.

Richard Davis with Canaccord.

This may sound silly in a world where you have Splunk trading at 12 times revenues. Alan, how do you think about -- and I understand the concept of investing because you've got a great product and these things. But how do you think about intermediate-term operating margins? Or is it just like you're sitting there, sitting in you chair saying -- listen, our opportunity is so big we've just got to pedal to the metal. And if our operating margins are 12%, that is perfectly fine, we are not losing money. And it may be 12% for several years. Or do you think to yourself -- hey, this thing is all of a sudden going to tip over on the margin side, even if you're hiring people aggressively and operating margins inch up to 20% or something like that? I am just trying to -- I don't, frankly, know what the right answer is, but I was just wondered how you think about it.

I think the opportunity is, as you describe, massive. I think we need to be responsible on how we spend money, and make sure we spend money wisely. I think the management team has been paying a lot more attention to that as we've grown. We do think that we should be able to get operating leverage. The reality is, over the next couple of years I'm expecting that it will improve because we will become more effective at capturing those stories and having more referencable customers that begin to create more demand that we don't have to cultivate quite as hard. At some point we're going to hit a tipping point and it will be less push and more pull. Until that happens, we have to get ourselves in shape to be able to take advantage of that. So, no, it is a terrific opportunity from our point of view. We continue to see that our competitors, our pure-play competitors are all largely gobbled up. One of them actually was just announced last week, is going to be now divested, out of progress. I think the market for us is terrific. We need to make sure we're ready to take advantage of it.

Got it. Thank you so much.

Brian Murphy from Sidoti & Company.

Did you comment on the sequential decline in maintenance revenue?

Yes, some of our maintenance revenue can be lumpy from quarter to quarter based on when people's renewals come up. In the Pega model, the maintenance contracts are self-renewing. In other words, it renews automatically unless you tell us otherwise. Some of the maintenance contracts we had from Chordiant were not auto-renewing and so we had to run around and get paper from these people and get them to re-sign. And oftentimes getting something signed can move from one quarter to the other. When we look at our renewals, it doesn't mean they're not going to renew, when look at our renewals we are at a 95% renewal rate from Q1 to Q1.

Okay. Could you give us a sense of how much cloud revenue is in professional services now and maybe how fast that's growing?

It is growing at a pretty good clip. Most of it is in a lot of development cloud environments, a lot of testing cloud environments. We do have people using it for production. A lot of people do development and then copy the application back behind their firewall once it becomes time for production. It's pretty large but it is not large enough yet to disclose on the financial statements.

I see. And is that having any impact at all on the service gross margin? It was particularly strong during the quarter, I'm just wondering if over time that should give the service gross margins a boost.

It will. And we will break it out when it gets to have an impact. The primary driver for the gross margin in the professional services in Q1 was the fact that we had three good contracts that ended in the quarter and we were able to recognize some revenue on them. So it was a good quarter for ProServ.

Okay, I see. And, Alan, I know you made some comments on Europe. But on a regional basis, your other bucket I think doubled. Can you just maybe comment on what drove the strength there?

A lot of it was Canada, which has been very strong for us, and it looks like it's going to continue to be strong for us. And we are also seeing some good things happen in the APAC space. But that was primarily Canada.

And also CapEx, year-over-year, a big jump there. Is that just timing or are you making some incremental investments there?

It is office buildouts. We opened an office in Paris in the quarter. We are about to open an office in Bangalore. We are building out the office in Cambridge in anticipation of a Q3 move. So that's where most of it goes.

Okay. And, Alan, you talked a little bit already about CRM. Can you give us just a sense of where you think we are in this call center replacement cycle opportunity?

I think we are still early. I think there is an enormous opportunity driven by a couple of different things. One, a lot of the call center systems and CRM systems that are out there are really pretty lousy. They really don't do a good job of supporting the agent, particularly if the businesses are complicated. The second is we are having very significant multi-channel conversations with our clients. Historically people built too much business function and business process into each channel. So they would set up a group, a special group, to go after the Web, and they would build all the processes there. And then the call center would get built and would inevitably be different and make it very difficult to roll out net products. Now with some customers going after mobile, a lot of them are saying -- boy, this is crazy. We need to have processes that are largely horizontal but actually allow you to go across these channels. With just the limited amount you need to be built into the channel, built into the channel. So I think it is being driven by both the normal replacement cycle that occurs on the back of a lot of those old Siebel and Clarify systems for people who were in that era. But it is also being driven by increasing need for people to adopt a more effective way to engage with clients. Which is also why we're excited about some of this unified marketing and other pieces that we're bringing to the market this year and will be showing off at PegaWORLD.

Got it. I appreciate the color there. Just one more and I'll hop off. A similar question on the oil and gas sector. Obviously we are in early innings there too. But could you help us size the opportunity in the oil and gas space? How big could that vertical be for you guys?

I think that vertical could be as big as insurance or healthcare or many of our other major ones. Probably not able to be as big as financial services just because there's so many of them. But when we take a look at oil and gas, we see a business that is highly concentrated, which we like. Which is global, which we like. That has complicated processes and the need to support both operational efficiency and operate with regulators. So it is really going to be a very good market for us. And the key is, now we have a couple of early clients. The key is to execute well, get those clients to radiate. And I think we could be looking at a strong year and a very strong year next year.

Okay great. Thank you very much.

(Operator Instructions) Edward Hemmelgarn, Shaker Investments.

Just a couple of questions. One, I noticed that you signed the agreement with the Texas Retirement -- County and District Retirement System. Are you changing your focus a little bit more towards state and local governmental units, away from trying to beating your head against the wall at the national level?

I'll tell you, what we decided to do is complement our head beating with increased focus on the state and local. And it has turned out great. We have won meaningful business now in half a dozen state agencies. And some of these states are very large and they really need operational improvement efficiencies. And we are thrilled. We are actually feeling better about the federal government too. The fact that we have not been, as of yet, as successful as we want at federal, which I've spoken about repeatably, doesn't mean we're giving up. It means we are trying different tactics. And I'm actually liking what I'm seeing there, to too. But it is really clear that state and local is going to be big for us.

Okay. The other thing is, any other new industries that you think you might be able to break into and see more growth in 2012, versus where you've been at before?

Yes. We had a really excellent great follow-on deal in the manufacturing space. Once again, it's the way we work. We go in and sometimes customers will make a big buy upfront. We're just as willing to work with them and have them really understand what we do. And then they followed up to come up with a system, a multinational system that's going to go in and wrap all their SAP implementation so that they can actually get more business benefit out of it. I think manufacturing which, frankly, plays a bit to the types of things you find in oil and gas, is going to be an increasingly good market for us. And we're looking for that to growth.

Okay. Thanks.

Thank you. And at this point I would like to turn the program back to our presenters for any concluding remarks.

Thank you, everybody, for the call. I'm sorry if I sound a little hoarse. The pollen is getting to me here in Boston. But we have been working hard. We are thinking that PegaWORLD, which you are encouraged to look up and take a look at our website, see what's there, is just going to be spectacular when you look at the people who are coming to speak and talk about what they do. We are expecting a really rousing event at the beginning of June. If you're available I am sure Craig would be willing to entertain a number of you.

All right. Look forward to seeing all of you in Dallas at PegaWORLD. It will be a good event and I think you'll really enjoy this year's presentation.

Thank you everybody. Have a good night.

Ladies and gentlemen thank you for joining today's conference. This does conclude the program. And you may now disconnect.