Pegasystems Inc (PEGA) 2019 Q3 法說會逐字稿

Good day, and welcome to the Pegasystems' Third Quarter 2019 Earnings Call.

(Operator Instructions) Please note, this event is being recorded.

I would like to now turn the conference over to Kenneth Stillwell, CFO.

Please go ahead.

Thank you.

Good evening, ladies and gentlemen, and welcome to Pegasystems' Q3 2019 earnings call.

Before we begin, I would like to read our safe harbor statement.

Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely and usually or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date the statement was made and are based on current expectations and assumptions.

Because such statements deal with future events, they are subject to various risks and uncertainties.

Actual results for the fiscal year 2019 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 Q3 2019 earnings and in the company's filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 31, 2018, and other recent filings with the SEC.

Investors are cautioned not to place undue reliance on such forward-looking statements, and there are no assurances that the matters contained in such statements will be achieved.

Although subsequent events may cause our view to change, except as required by applicable law we do not undertake and specifically disclaim any obligation to publicly update or revise these forward-looking statements, whether as the result of new information, future events or otherwise.

And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Ken.

Three quarters of the way through the year, I'm pleased with the state of the business.

We continue to make strong progress in ACV growth and our transition to Pega Cloud.

We've been executing on our strategy to increase our sales capacity in response to the large opportunity ahead of us, and I am pleased with the early returns on the effectiveness of the sales team as reflected in our pipeline growth.

Ken will provide more context on our financials in a few minutes.

Now in terms of sort of insights on the market, as you're aware, we're seeing lots of disruption around the world with things like Brexit and trade tariffs, and our clients are looking at how to plan for any number of changes they may face.

Now our underlying model-driven low-code architecture allows for our clients to adapt quickly to change, and to really grow their businesses and develop their efficiencies.

We continue to see an enthusiasm for our software.

Now our digital transformation technology helps organizations establish an operational backbone that can be used equally to either propel top line growth and drive bottom line efficiency, shedding unnecessary technology overhead and also making operations and client engagement more efficient.

Pega's intelligent automation solutions optimize operational and employee efficiency, as I said, while our decisioning capabilities improve the retention and lifetime value of client engagement by ensuring the right actions or offers are provided at the right time.

This ensures not just a great client experience at the moment of outreach but also the ability to drive preemptive customer service, anticipating potential issues so you can address them when they have a better chance of being mitigated.

Now the market has been interesting because we have continued to see a lot of hype in the market, including crazy valuations that don't reflect business fundamentals.

And this has been especially true around some of the hot technologies, like what they call robotic process automation, or RPA, as I talked about on the last quarter's earnings call.

We think there are better ways to go after the market from both a technology and marketing and solution perspective and, frankly, see a validation of that in some of the recent events.

As one analyst said in response to the recent layoffs of a major RPA vendor, "They're realizing that intelligent automation is a marathon, not a sprint.

It pushed the hype around RPA far too aggressively." He went on to say, "It is imperative that enterprises invest time and resources evaluating their business processes before taking the plunge buying software that will deliver only once the business cases have been defined."

Now this is very consistent with Pega's approach and our view that RPA is great, but it should be used as an extension of true intelligent automation and true end-to-end digital process automation.

And I think that bodes very well.

If you know our history, you know we've been through up and down business and financial cycles, and we know how to sell in both of those environments.

And unlike others that appear to have gotten ahead of themselves, I don't expect you'll see us having to retrench because of overhype should the business environment change.

Now in terms of client trends, historically, we've focused almost exclusively on the largest, most sophisticated clients and projects because we feel we uniquely have the expertise and the technology to handle them.

And we're still tackling those as our clients are continuing to roll out important new major initiatives.

But we're also seeing our clients want to start quickly with other types of initiatives and then add value rapidly while they learn and adopt best practices.

This could mean being more agile and starting small and fast, but the confidence that we can scale with them successfully to deliver what they need as things get bigger.

Many of these projects center on identifying what we call focused micro journeys, sometimes, people used to describe as use cases, and as I talked about at PegaWorld, a series of single interactions with a customer that can change their experience in a significant and positive way.

We provide structured design thinking approaches to identify key challenges and define the right problem to solve and the right customer journey to tackle first.

And we're working to establish an increasingly repeatable standard way to go after these.

This message is resonating, and we continue to see strong new business momentum across our geographies, our applications and industries.

This quarter, I'd like to highlight the great progress we're making in the government market.

Government is full of what we call case management and processes and the need to drive effectiveness and efficiency.

And I've just returned from our Government Empowered event we held in Washington, D.C. on Wednesday.

Clients and prospects from around the world joined us to hear how government agencies are working with Pega to tackle digital transformation and modernize legacy systems, all while navigating the privacy and policy constraints.

We had a terrific line of speakers, including Suzette Kent, the Federal CIO as well as senior representatives from the FBI, the U.S. Census Bureau, the Department of Veteran Affairs and the Air Force Research Laboratory.

Just like our commercial clients, they are looking to digital to drive improved engagement, and governments worldwide are increasingly focusing on their constituent experience as they seek to improve satisfaction while they're driving better efficiency.

There's a big push to modernization in the government, and we're very well suited to handle that.

That trend is working to our advantage, and we're making nice strides in the government market, adding important new business globally.

This quarter, for example, we won new business at one of the largest U.K. government departments who's been a long-standing Pega case management client, who recently purchased Pega Customer Service running on Pega Cloud to provide a single adviser user interface for their 30,000 customer service center staff.

This is a first step towards a wider program to transform customer service within the department.

And the first live call was taken using the Pega solution after just 4 sprints, about 8 weeks from project start.

A major Department of Defense command is using the Pega Gov cloud in the U.S. to improve command's overall objective of annual audit readiness by improving financial management processes and enhancing internal audit controls.

A deciding factor in choosing Pega was our digital process automation capabilities which, as I said, include end-to-end automation with robotics, which enable the command to automate and integrate processes with other critical internal enterprise systems even if they're quite old and without APIs.

The U.S. federal government also selected Pega as the intelligent business process management platform for building an end-to-end grants management solution.

Pega will serve as a central component of the new system, orchestrating all grants' life cycle activities and maintaining key grants management data.

The unified system will replace multiple legacy systems and establish common business processes across several different grants programs.

And going overseas for a moment, the French National Authority for Health chose Pega cloud software to manage a new certification that will create quality rankings used to evaluate all French hospitals.

Now it's not just these sort of direct sales, lots of sales actually operate through partners.

And our partner relationships is something that's very important.

We have a situation where the largest Medicare service operation chose Pega to transform the way they serve their ever-growing beneficiary population, providing seamless and frictionless service experiences.

Now in addition to government, we continue to see strength across our other verticals.

And it's terrific to see new business coming through a range of clients from one of the largest global CPG leaders to our relatively new consumer groups.

So it's actually -- I think is moving forward very much in a positive way.

In terms of marketing, on our last call, I mentioned that we're continuing to increase our focus on getting visibility and engaging with our customers.

And then we had a number of regional events like the one we just had in Washington, which we call customer engagement summits.

These are scheduled throughout the year and are proving to be valuable venues to reach new audiences and increase our visibility in a targeted way.

This year-long multicity global road show complements our annual PegaWorld conference.

And this year, on the road show, we will be face-to-face with nearly 10,000 additional prospects and clients around the world, about half of which are net new to Pega.

Since we spoke, in addition to the Government Empowered in D.C., we've also held events in Detroit, Boston, Melbourne, Munich and Tokyo.

And they're driven by amazing client stories of real work done by Pega and with Pega, which are inspiring and include organizations like Celgene, the Commonwealth Bank of Australia, Delta Dental, FordDirect, Express Scripts, the Japan Ministry of Economy, Trade and Industry, Siemens, Sanofi and Royal Bank of Scotland.

We're very honored that our customers are willing to come and talk to others about what they're doing and what they're achieving.

And we'll be continuing this series into 2020 as well.

So in summary, we're pleased with the progress 3 quarters of the way through the year.

We think we have strong momentum, and we're working hard to try to finish the year as strongly as possible.

We continue to see a great market opportunity, and we're confident we have the right capabilities and the right strategies to help clients succeed.

To provide more color on the financial results, let me turn it over to Ken Stillwell, our CFO.

Thank you, Alan.

We've executed well through the first 3 quarters of 2019.

Our team delivered solid growth in ACV, continuing to increase new recurring license and cloud commitments.

We continue to be excited about the huge market opportunity in front of us.

We're executing on our plan to increase selling capacity and go-to-market resources to better penetrate our target accounts, and early returns show very healthy pipeline growth as we enter Q4.

As we continue our transition from a company that largely sold its software on a perpetual license basis to a much larger company that sells mostly on a recurring cloud license basis, ACV growth continues to be the most important metric that reflects the successful execution of our strategy.

Total ACV is the sum of recurring Pega cloud and client cloud commitments, representing the annualized spend by our clients for subscriptions, term licenses, and maintenance.

At the end of the third quarter, our total ACV was $634 million, up $106 million or 20%, consistent with our long-term target.

Pega cloud ACV grew 51% in the same period.

Both of these measures are in constant currency.

We continue to transition our business to a recurring model, leveraging our market-leading cloud choice differentiation.

For the first 3 quarters of 2019, 57% of our bookings were Pega cloud.

Those results are 7 percentage points higher than we originally anticipated.

As I explained at the beginning of the year, we planned for Pega Cloud to be 50% of our new commitments in 2019.

This 7-point difference in Pega Cloud results has the short-term impact of reducing revenue by about $3.7 million for each 1 percentage point or approximately $20 million for the 9 months ended September 30, 2019.

Turning to remaining performance obligation, also what we call backlog, Pega Cloud backlog increased by $100 million to $363 million at the end of Q3, an increase of 38% from 1 year ago.

Total RPO increased by $86 million from $522 million to $609 million, an increase of about 17% when compared with the balance as of September 30, 2018.

A robust backlog is another benefit of our cloud transition.

Historically, much of our bookings were taken as revenue in the current period, sometimes causing variability in our quarterly results.

These days, the largest portion of our bookings are cloud, most of which goes into backlog, creating a more predictable revenue and cash flow stream in the future.

Our deliberate ongoing transformation to a recurring business model continues to track as planned.

As we've discussed in the past, a cloud transition typically takes a software company about 5 years to complete.

As we begin 2020, we expect to be directionally at the midway point of our cloud transition, accomplishing this in somewhere between 4 and 5 years.

In our cloud -- if our cloud transition continues at this pace, we expect optics to improve in 2020 and '21 and normalize during 2022.

We remain very confident that the long-term benefits of a recurring business model, including a more predictable future revenue and cash flow stream, far outweigh the skewed short-term optics around reported revenue growth and the impact to near-term cash flow and reported EPS.

We're confident that a greater mix of recurring contracts is the correct long-term strategic direction for our business and matches the market demand.

However, in the short term, moving away from perpetual bookings replaces large upfront cash and revenue with cash and revenue that will be received and recognized over multiple years.

We expect the lag between the business we win and its revenue and the ensuing mismatch between revenue and costs to diminish over time.

The impact of our cloud transition can be seen in our reported results.

Revenue for the first 3 quarters of 2019 totaled $635 million, effectively flat when compared to the first 3 quarters of 2018, while ACV, on a constant currency basis, increased 20%, and cloud backlog grew 38% over the same period.

I want to reiterate that we started the year with an expectation that Pega Cloud commitments would make up about 50% of new bookings versus the 57% we saw through the first 3 quarters of 2019.

As a reminder, each 1% shift to Pega Cloud has the potential to reduce full year revenue by approximately $3.7 million for the full year 2019.

Pega Cloud deals that are reflected in ACV, but it is largely not reflected in current period revenue.

Therefore, if you adjust for the impact of this transition and the higher cloud mix, the year-to-date through 3 quarters in 2019 is approximately $20 million.

Moving next to revenue components.

Pega Cloud revenue grew an amazing 63% to $95 million and maintenance revenue grew by 6% to $207 million for the first 3 quarters of 2019 versus the same period 1 year ago.

Our consulting revenue was $167 million, a year-over-year decrease of approximately 15% or $29 million from the first 3 quarters of 2018, which is consistent with our strategy to shift an increasing proportion of implementation effort to our SI partners.

Additionally, we had a very large government contract, where we have significantly enabled the client, reducing the necessary involvement for Pega, which also we consider a strategic move.

As I mentioned earlier, our Pega Cloud transition creates a temporary mismatch between reported revenue, margin, EPS and cash flow.

This effect is further magnified as we continue to invest in increasing go-to-market resources to accelerate our growth.

And with demand for Pega Cloud exceeding even our expectations, we continue to build out our cloud infrastructure to scale this significant growth engine, which also has a near-term negative impact as we invest in Pega Cloud.

For the third quarter of 2019, we're reporting both GAAP and non-GAAP results.

A full reconciliation of all GAAP to non-GAAP measures is provided in the financial tables in the press release issued earlier today, and those are also available on the Investors section of our website.

So let's turn to a few other details.

We finished the period with total cash and marketable securities of $113 million.

In the first 3 quarters of 2019, we returned about $62 million to shareholders comprised of about $7 million in dividends and approximately $55 million in share buybacks and net settlements of equity.

As we finished the quarter with just over 5,000 employees worldwide, an increase of approximately 13% from 1 year ago, more than half of our employee growth is in the go-to-market organization.

In summary, we continue to be energized by the size and growth of the digital transformation market opportunity in both the front and back office.

I just spent the last few days with Alan speaking directly with numerous government clients and prospects during our Government Empowered conference in Washington, D.C. I continue to be impressed by the value we are bringing to these organizations.

Customer demand for digital transformation solutions continues to be strong, especially in the public sector, where Pega is a perfect fit.

Traditionally, the fourth quarter is our largest quarter, and we expect this year to be no different.

In summary, we're very pleased with our year-to-date execution against our strategy, and we're focused on finishing what has been so far a solid 2019.

I look forward to seeing investors over the next several weeks as we get on the road.

And with that, operator, we will open the call to questions.

(Operator Instructions) The first question comes from Steve Koenig with Wedbush.

Congrats on a solid quarter.

Maybe 2 questions here for you.

First one, Ken, for you.

Spending growth.

So are you guys still kind of, as we look at the numbers, you are kind of targeting mid-teens for the year?

It looks like you were substantially above that in Q3, if I did my numbers right.

Maybe just some color on, is there some quarterly variability here or are you still kind of tracking to the original goals?

And where do you anticipate spending?

So good question, Steve.

So the 2 things to think about is our go-to-market investment is still on pace to be directionally in line with what we had talked about at the beginning of the year, which is investing in kind of that low 20% range of investment.

The one area that we've actually had increased investment year-to-date, that is in Pega Cloud.

And that really relates to 2 factors.

One is that our Pega Cloud business is higher, is growing at a faster pace in terms of new bookings than we anticipated, and that -- and we need to invest for that faster pace.

If you think about Pega Cloud, we're investing in advance of the booking and the booking doesn't even get us revenue.

So there is somewhat of a disconnect on the cloud gross margin line because you don't get the revenue, but you do need to invest in the business.

And then secondarily, you will remember that we got our Pega -- our FedRAMP certification earlier in the year.

And with public sector being a very important part of our strategy, we've ensured that we have the right resources to support our public sector clients moving to the cloud at an accelerated pace.

Okay.

So just to follow up on that, and then I'll ask my question for Alan now as well.

The, kind of what you're spending, the trajectory here on cloud, as your cloud mix is shifting faster and your cloud revenue growing fast, is that something we should expect to continue?

Because as I look out, it looks like The Street isn't really growing [FX] fast enough next year.

And so kind of, does that cloud investment continue?

And how long does that continue?

And then I'll just ask my question for Alan now.

It's about maybe just an update on project FNX, kind of where are we with that.

And maybe a little color on, are we looking to see more multi-tenancy from Pega out of some aspects of that?

And could there actually be sharing of components or some kind of ecosystem around that in time?

So I'll answer the first part of your question, Steve.

You would see, because of the higher growth in Pega Cloud and the fact that, that won't turn into revenue in the short-term, but we need to invest for a larger client base, you would expect a little bit of a slower growth in our track to our kind of terminal gross margin target.

So you would see more investment in Pega Cloud in 2020, and that would be commensurate with us having a bigger book of business.

So think about the Pega Cloud being tied to the backlog just as much as it is tied to the revenue.

And so since the backlog is outpacing the growth that we anticipated.

And if that continued in '20, we would expect the investment to continue in '20 as well.

And then I'll hand it over to Alan for the second part.

The other thing I would just say about expenses, we've decided to work to both, for example, get our FedRAMP certification.

We're shortly going to announce that we have IRAP, which is the Australian certification which we've been approved for.

And we're doing a variety of these.

Being able to go through those does have some short and intermediate-term expense, both in terms of going through those processes and you have to set up and demonstrate that you can do that on an ongoing basis.

But also getting people with some different skill sets and clearances that might be necessary to be able to work with those clients.

That will, -- we would eventually expect will slow down [year].

But I see it for the next at least 6 to 12 months, I would think.

In terms of FNX, I'm very, very excited.

When you go and you talk to clients or prospects about what is a major technical change, in a lot of ways that's almost contrary to where we were really trying to focus on business improvement.

But the level of enthusiasm since we had our first introduction in detail in June at PegaWorld and did the deep-dive with about 150 architects from various customers, the feedback from them and also just a whole variety of sessions we keep having about it, outpaced my expectations.

And there's a huge amount of enthusiasm.

And the whole notion that we can move and our clients can move to just an absolutely state-of-the-art React-based front end, no JS environment, without having to like rewrite all their applications is exactly the promise of doing things correctly in a model-driven way.

So there's a lot of enthusiasm.

We are building multitenancy into that capability.

So we're expecting to have, in effect, 3 levels.

Some customers and smaller ones with lower risk might choose to operate on a general multi-tenant environment, which we would expect, frankly, just higher returns on.

Others may want to be multitenant for a single client.

So for example, all of a single large customer of ours might be on a single multitenant system, which provides additional and more secure options vis-a-vis encryption.

And then we still of course will have customers who will want to operate and will merit operating on a single tenant basis.

So we're building it to be able to hit all of those as well of course continuing the whole vision of which, by the way, is being endorsed by the market, of client cloud choice which I think was one of the really smart things we did.

The next question comes from Rishi Jaluria with D.A. Davidson.

Maybe I want to start with the gross margin side.

It looks like we saw actually negative gross margin from the consulting and training business and cloud gross margins declining a little bit, and I understand there's obviously investment in cloud pretty aggressively without necessarily having the revenue yet.

Maybe help me understand both of these pieces.

Why are we seeing -- especially if you're offloading more services to partners, why are we seeing services gross margins now negative?

And then maybe what's the path to get from where we are today to, I believe you said in the past, about 65% cloud gross margin.

So I'll take the -- in the order of the, the first is professional services.

So we are having a lot of success having partners be more involved in our ecosystem than they historically were years ago.

And although that is a -- although that's a great kind of force multiplier for us to grow the business, we still do quite a lot of implementation work for our clients.

And even though our revenue is taking a hit as more partners are engaged in implementations, there's a lot of precious skill sets that we have at Pega, and we know that we will need those resources in the future as we scale the business.

And so there's no knee-jerk reaction that we would take to change the sizing of our teams because our resources and our professional services team are the best that are out there.

And we would think that we would want them or we would want to make sure that they are used to support -- sometimes our professional services team members go to work for our clients.

So the professional services margin is something that will settle over time as opposed to being something that we would try to rightsize quarter-to-quarter.

On the gross margin for Pega Cloud, that -- the timeless kind of longer-term target margin was to be above 70% actually.

The 65% certainly will be somewhere -- it will not be a linear move to 70, but 65 will be probably a step in that journey.

We expected our gross margin to be, honestly, a few percentage points higher than where it is right now.

But given the scale growth of cloud, the fact that we need to invest in advance, as Alan mentioned, we have not only FedRaMP, we had international cloud environments like IRAP certifications, et cetera, that require us to make sure we're ahead of the game.

So some of that investment, we had to kind of pull up a little bit in cloud.

It doesn't impact our longer-term margin targets.

It's more the timing of investments coming on the front end of the cloud growth as opposed to a more linear investment.

Got it.

Ken, that's helpful.

And then a two-parter for Alan.

First, just wanted to get a sense of if you're seeing any changes in the buying behavior from customers.

And any sort of color you can share on EMEA, especially after what you told us last quarter.

And then maybe just wanted to get a sense of where you are in terms of the journey to increase your sales coverage, maybe how far we are in that direction of getting to the ideal sales coverage that you want to see.

Sure.

So one of the things that was gratifying is we saw some resurgence in EMEA.

It's a very unpredictable environment that we're all dealing with here.

But certainly, there is strength and a lot of interest, both in the U.K. but also in some other parts of Europe as well.

Relative to the growing out of the sales team, we're making good progress.

We've done a lot of work to, I think, improve our recruitment approach, and that's both in terms of being more effective at engaging candidates and also, I think, frankly, being really, really quite selective.

What I'm excited about on that front is we're actually finding people who are themselves, for example, making "very large" competitors actually now very open to both talking to us and, in many cases, joining us.

And I think that's because they've competed against us, they see we're becoming more effective.

And frankly, I think we have a lot going for us in terms of the culture of the business and commitment to client success in a very genuine way.

So I would say that we're going to continue to do that and continue to grow that.

We did do a big push in marketing spend as -- through Q2 and Q3, we're guiding a lot of these conferences and these events.

I'm definitely seeing a return from them.

So those are not going to continue to increase at a, even a proportional rate.

But we are going to continue them in sort of the style and way that we're doing them today as we go into next year.

And one thing to add, Rishi, on the question about EMEA.

If you look at the performance of our sales team with respect to kind of growth in ACV, and you look across the world, the -- our performance to kind of our plan has been fairly consistent across the geographies.

So we're -- so that using that as one measure, it's not the only measure, it looks like there is demand for our solutions in all of our major regions.

The next question comes from Pat Walravens with JMP Securities.

This is Mark for Pat.

You highlighted success in the federal and I'm just wondering, could you talk about how is the sales motion different there.

And maybe what's your partner strategy in that sector?

So can you repeat the sector?

I'm sorry.

Public sector.

Public sector.

So obviously, you're dealing with more partners in the public sector and the sales are very much linked to having good partners.

So our sales teams are engaging both with the ultimate department but also with the partners as well.

We're seeing, I would say, an acceleration in that sector.

It's very exciting.

I would tell you that the growth in the sector has actually been extremely encouraging on a year-to-date basis.

So as these guys pursue modernization, we're just a terrific way for them to save money and for them to also get closer to the citizens.

So partners I think are more enthused.

I do think that you're going to see us having a lot of wins in the next year and coming off of the Government Empowered event, it was just yesterday, it was just awesome.

It was extremely invigorating and exciting, and there are even videos that are going to be put up on the website and things we'll let other people share in it.

So it's all good from what I see.

Maybe just a quick follow-up.

And is RPA a popular topic with the federal customers?

Yes.

I think desktop and process robotics is a popular topic with -- absolutely, with customers.

There's really been a lot of attention paid to that sector.

And I think at one point there was a lot of confusion as to whether that was like, the cure-all miracle Band-Aid that was going to render everything obsolete.

I think customers are getting a lot smarter and are understanding better that their initial -- a lot of these companies were selling $5,000 and $10,000 deals to enormous companies that frankly I would classify as just experimentation.

Based on those experiments, we're finding that people have a finer understanding of how we are going to use robots.

You really do need an end-to-end process automation system to be able to tie them together, and that's what you need for intelligent automation.

Just putting intelligent automation as a buzzword on your website doesn't do it.

So I think the increasing sophistication of buyers and that very much is true in the federal government as well, is extremely beneficial for us as we continue to compete in the RPA market as well as the DPA market.

(Operator Instructions) This concludes our question-and-answer session.

I would like to turn the conference back over to Alan Trefler, Founder and CEO.

Please go ahead.

Thank you.

And thank you, Ken, and thank you to all our investors.

Now we're working hard on your behalf, and we're really excited and we're going to go back to work now.

So thank you very much all.

The conference has now concluded.

Thank you for attending today's presentation.

You may now disconnect.