PagerDuty, Inc. (PD) Earnings Call Transcript & Summary

Thank you for joining. My name is Koji Ikeda. I'm the software analyst here at Bank of America. Super thrilled to have Howard here, CFO of PagerDuty. Thanks so much for joining us. excited for this conversation. Yes. So let's just kick it off here for those in the room and on the webcast that are not familiar with PagerDuty. Just maybe a real quick overview of what does PagerDuty do? What is the opportunity that you're addressing? And maybe a little background on yourself. Who is Howard? What do you do in at PagerDuty? What brought you to PagerDuty?

Sure. Well, let me start with PagerDuty first, Koji. So PagerDuty is a platform that helps companies manage their digital operations. So we often talk about our Operations Cloud, which really is a combination of 4 elements or 4 pillars. One is around helping companies manage their incidents. The other is around using AI to manage operations. The third is around automation, both workflow and process automation. And the fourth is around integrating customer service operations so that you can ensure that you are able to manage all the signals in your environment, both those that are coming from the instrumentation that you put in from your observability vendors or from your change products or from your ticketing systems that you're able to collect all of those signals into the Operations Cloud platform and human signals that could be coming from customer service agents and then orchestrate the right work so that you're actually getting to address the most critical issues that could be facing a company at the right time with the right people. So that's what we do, really orchestrating people together with systems to be able to help companies be effective in their own mission. Why I'm with PagerDuty is an interesting story. I've been with PagerDuty coming up for 8 years now. I have joined PagerDuty when it was a much smaller company. We weren't yet at $50 million in revenue. We were at about 150 to 170 employees. And we were really just getting started with addressing a very real problem, which was people who were working in on-call environments were being subject to a lot of stress in terms of being able to deal with the workloads that were coming their way. And we had really good product market fit in our original use case in incident response, which was really improving the lives of developers and engineers who are on call and being able to give them the context that they needed to be able to solve problems. And I've fell in love with the company, originally started out doing some consulting for the company, was the Chief Commercial Officer for a while and then been in the CFO seat. I think for 5 or 6 years now.

You've seen a lot of PagerDuty over the years...

Yes.

So you guys just reported fiscal first quarter results last Thursday. And so just maybe a recap. What are some of the key takeaways that you want to highlight? It has been about 5 days since you reported... 4 days... Thursday last week...

Yes.

So you've had some conversations over that, so what has been most topical coming out, the key message, and what has been most topical amongst the investor community?

Sure. I think when I look at the results, for me, a highlight was the fact that we have stabilized our ARR growth rate at 10%. So it's 2 consecutive quarters of doing so. We continue to demonstrate good strength in terms of profitability. So we delivered 14% operating margins in this quarter. And this is part of a track record now of many consecutive quarters of profitability and strong free cash flow generation as well. So those to me are some of the key elements that purely by the numbers, to me, are real highlights. I also think the other side of it is we're definitely seeing the company has made the right adjustments to the economic environment. So we decided more than a year ago when some of this economic dislocation became evident to start making some very intentional changes about how we addressed the market, how we engage with our customers, how we build our value proposition. And as a result of that, when I look at the deal profiles of the deals that we're doing now, there are increasingly multi-product, they're increasingly multiyear, and they are larger. So we are seeing a higher volume of deals above $100,000. We're seeing good progression of customers in our greater than $100,000 and $500,000 and greater than $1 million ARR spend with us. Those for the greater than $500,000 and greater than $1 million, we saw high upper teens growth in terms of those companies, their spend with us. And so it's been really encouraging for us to see that, that progression as we prioritize the enterprise is bearing fruit. And when I step back and look at how our go-to-market team is developing pipeline, we're seeing the development of long-term pipeline. As a company that previously had visibility only out to 1 quarter, we now actually have increasing visibility, in fact, into half past into the next fiscal year.

It's been pretty interesting in the software world, I would say, over the past 6 weeks with lots of different companies reporting. And you guys posted pretty good results last week. And so the question is really about the macro and the demand environment. What are you seeing out there? How would you categorize the demand environment for PagerDuty specifically today, I guess, as real time as we can get or you're comfortable disclosing today, how would you categorize that 6 months ago and maybe a year ago?

Yes. So I think the macro remains uncertain is probably the way that I would describe it. I think that there isn't necessarily one consistent theme or message that you would see across all customers or all enterprises. But I think there are high levels of uncertainty even within our customer base. I think companies are being cautious about spending because of that economic environment. And what that means is that spend needs to be well justified and it needs to align with the company's strategic priorities. So when I look at that within the context of PagerDuty, what we've been doing is really reeducating our sales team to ensure that they are connecting with the executives in our accounts to ensure that what we're proposing in terms of our solutions with the Operations Cloud is, in fact, aligned with what's important for our customers. Internally, we often talk about solving big problems for big customers. And that is certainly, I think, important in this economic environment because if companies are going to make investments in your software and services, they need to be sure that there's a really good return. And that's become a characteristic of what we've been doing over the past 12 months. Now that uncertainty in the environment persists. We have not expected or haven't contemplated an improvement in the macro environment in terms of the guidance that we provided for this year. But we are looking at it closely. And I think that there are a few trends that will continue to ensure that companies need a robust platform to manage their operations. So companies are all sitting with huge amounts of technical debt, despite all the discussion around digital transformation for more than 10 years now, it's still not done, right? So companies are still trying to drive improvements in the operations. I think with AI and almost every company feeling that they need to have some sort of AI strategy and being able to think about how do they leverage AI. So that's going to create a whole new set of challenges around how do you manage AI responsibly within your digital operations. And again, PagerDuty has a key role to play in terms of how do you manage all the way from detection through to being able to manage a potential incident to being able to drive automation in terms of diagnostics or in terms of remediation, to then being able to perform incident analysis and in fact, learn from it and close the loop. So those trends, if you like, all those characteristics of what businesses are dealing with, I think will continue even in this environment. So we remain, from a company perspective, very focused on ensuring high alignment. And that's why even with our approach to thinking about building our pipeline, we've been very intentional about ensuring that as we think about account planning and building engagement with our customers that we start with the customer's problem as opposed to starting with our product. And that has certainly created a different dive.

I want to follow up on the pipeline. So thinking about pipeline, I guess I got a bunch of questions here. How would you categorize the pipeline today versus let's just say, a year ago. But more importantly is how should we be thinking about pipeline conversion? What have you done to either improve or maintain the pipeline conversion? And how are you expecting pipeline conversion to be in the future?

Right. So I think the contrast of like last year versus now, I'd say the big distinction is that the visibility of our pipeline has improved significantly. From a year ago, if we looked at our business even pre Q1 of last year, the majority of our business was actually identified and closed within the quarter. That changed, right? Now we find that with sales cycles lengthening, we actually have had to reorient around a different sales process that recognizes that deals will take longer. So if I look at our pipeline today, we now have visibility of our pipeline that goes out at least 4 quarters, right? And so that pipeline visibility is super helpful for us. But also that's because deals are taking longer because companies require higher levels of justification upfront for spend. Now when I look at pipeline, I always think about quality because it's all very well to say, well, okay, going just create some pipeline in some future quarter. So the diagnostic and the metrics that we apply to our pipeline are really around looking at pipeline quality levels of pipeline qualification, prescriptive practices around how we expect pipeline to progress and mature and qualify out there has got a real opportunity. So those disciplines are disciplines that we put in place. And we use technology through our forecasting and analysis tools that would be used to help us service and understand what's happening with that pipeline. We track conversion rates closely because, obviously, they become a predictor of what you are capable of doing. And in the last 12 months, as we transitioned into this mode of having to manage pipeline over a longer period of time, we've got a better understanding of what that pipeline looks like. In fact, this past quarter, a large number of the large deals, even though that we referenced on our earnings call were deals that actually had started in the pipeline 9 to 12 months ago. So that represents a complete shift for us as a company in terms of high velocity, lower-value transactions to kind of these higher value but longer-term transactions.

So to dig in a little bit more here. It sounds like the pipeline coverage ratio needs to be higher today than the past.

Correct.

That's correct.

Yes, because it's different in that it's not necessarily that it needs to just be simply higher as a multiple because there are other measures that you're using to drive pipeline efficiency or conversion efficiency, which includes improving the productivity of your sales reps. So you have to do both. You have to be able to generate higher levels of pipeline with a longer term. So you're trying to generate pipeline not only for the next quarter but for multiple quarters out. And you're trying to improve the productivity of your sales rep. So investing heavily in things like marketing programs, enablement that actually will increase the level of conversion.

And so the flip side, the positive side, take it for what it's worth on the pipeline conversion side. But on the conversion side, it sounds like you are much more comfortable and have higher visibility and more confidence in ability to close and know when to close. So does that imply that the very, very high levels of confidence in the guidance. Is that kind of the...

Yes. So I will reword it this way. Based on the visibility that we have now and looking at the heuristics of how things have played out even for us in the last few quarters where we've now had several quarters of strength in enterprise, both in terms of new and expansion. That gives me the confidence when I look into the back half of the year that we have built the pipeline and are building the pipeline that will allow us to modestly accelerate our growth in ARR in the back half of the year and modestly improve our dollar-based net potential in the back half of the year.

Got it. No, that's super helpful. Okay. So big deal activity. When we look at the transcripts over the past several quarters, I mean you guys are landing some pretty big deals out there. And so you mentioned earlier ROI. And so it does feel like a component of ROI is helping kind of big deal activity. And so can you talk about maybe the pain points of the triggers that are really fueling this big deal activity? Is it the same today that it was before? Is ROI a key factor that is driving big deal activity?

Yes, sure. So our customers are typically looking at ROI across a number of dimensions. A lot of them are in the mode where they are having to essentially deal with an increasing workload but with less resource, right? So for them, the key element for them is to see can they improve the productivity of the resources that they have in order to manage expenses more effectively? So the problems that we solve in that respect are manifold. And I'll give you one example, which is often around how do you drive higher levels of automation in terms of orchestrating people around managing an incident? So one of our solutions is very much focused around incident management transformation because that ties to 2 things. For a company that relies on their digital operations to drive their revenue. If they have degraded performance for even a minute or 2 or 10 minutes or 20 minutes, it has a real impact in terms of revenue loss. So the first thing we try to ensure is that you can orchestrate the right people in the right time to prevent that revenue loss or minimize that revenue loss. So that's a key element of the ROI. The second piece is often, if you have an ineffective mode of ascending people or orchestrating people around a particular incident, you can end up spending or burning a whole lot of resource or solving a problem with people who have no ability to solve it. So worst-case scenario, you get 100 people, you join a conference call when in fact, 5 people would have been enough or you have 10 teams working on trying to identify the problem. When, in fact, if you had all the rich context provided by AI Ops, you could actually get to the problem in minutes, right, as opposed to having people go up and do that. So we have an ROI in terms of the productivity that we're then delivering within that framework. And then being able to deliver a better customer experience, often companies look at them and say, "Well, how does this affect my reputation? Or do I have compliance requirements? Have I been able to actually meet the compliance requirements when I had an incident? And we aim to then help them demonstrate that that's the case. So there's so many different vectors in terms of looking at this. And we've become far more confident in having those discussions with our customers around the impact that we can add.

When you mentioned resource constraint earlier, I wanted to dig into that a little bit. I mean you could think about that in 2 different ways, from a people perspective and a technology perspective. So when you are selling into customers and they're saying we're resource constrained, are you finding that customers are saying, "Hey, I got 100 people, can I deliver more value or better performance, better response with 80 people?" Or are you hearing them say, "Got 100 people. I don't want to spend any more on this software. I'm going to spend it with you to take those 100 people and get them better." Yes. So what are you hearing out there from...

So I think it's a combination of those, right? I think it's both the case of like I'd like to do more with less people or I'd like to do more with the same number of people. But increasingly, it's a case of people are feeling this in charge, it has made a too strong a word, but people feel that the investments that they've made in technology are not yielding the results that they would want. So we often find that customers have very immature processes around how they manage their digital environment. So they may have made a number of investments over time. And they've sometimes confounded these with manual processes and with a whole homegrown systems, which all require effort and maintenance in some shape or form. And so our ability to help them transform that is where the value lies. So it's not necessarily correlated directly to purely the humans. But it's about, well, could I consolidate this point solution that I have? Or could I get rid of this homegrown solution that I have that's impossible to manage? Or could I drive efficiency with the process improvement and the cultural change that we would drive?

I wanted to switch the conversation over to AI. Everyone's favorite topic. So just thinking about AI, from a very simplistic approach for the end market that PagerDuty is going after, does the end market fully understand what AI could potentially mean? Question #1. And are they still trying to figure out what does AI specifically generative AI and LLMs mean for something like an incident response platform because in a very simplistic way, you could arguably think why can't we just shut all that data into an LLM and just say, "Hey LLM, what's this incident, tell me who needs to fix this?"

Yes, I think that's a great question. And I think like from a context perspective, what I would say is like PagerDuty has been in using AI for 8 years now, right? And that's the predictive AI component, and that's at the heart of our AIOps solution. It's embedded in our platform and helps us deliver a lot of capabilities, and it's important in terms of the data set that we have that has helped us drive a lot of improvement already. So when I look at it stepping back from PagerDuty, I think customers are thinking about AI in terms of how do I use AI more effectively to manage my operations, but how do I do that with high fidelity? Now part of PagerDuty's reputation has been founded on us being the high fidelity platform, right? We cannot be telling people that there's a problem where there isn't one or vice versa. So we've always put a lot of emphasis on our reliability, our scalability and our ability to provide you with meaningful data. Sometimes the fact we only wake you up when you really need to be woken up because from an incident management perspective because we feel that's so critical. So when we think about AI, particularly the use of generative AI, we think it creates a wonderful intuitive interface to the PagerDuty platform. But we're approaching it very intentionally in engagement with our customers. And we actually have hundreds of customers using our AI and generative AI offerings, our AI assistant in early access because we want to be sure that we get it right. We cannot afford to get the wrong answer in these circumstances. So our investments in AI have been very much focused on how do we help support the processes, the operations management process that our customers have. It could be things that are human intensive that we can reduce down significantly. It could be about how do you provide people with information on demand through a prompt just what they need like tell me how my service is doing or catch me up on this incident. Those are all valuable use cases or it could be us supporting both kind of a no-code low-code and pro code approach to how we think about automation with helping people create runbook automation. So there's a number of different areas in terms of how we think about the use of AI. But all of it is ultimately about ensuring that people can manage their digital operations more effectively.

Yes. That makes sense. I'm going to ask you one more question, then I did want to open it up to the audience to see if there's any questions from the audience. SMB side. How would you categorize the health of the SMB segment. I think it's been somewhat of a drag on the overall business. You could see in some of the customer metrics. And so how do we think about SMB? Does it improve? When does it improve? All those types of questions.

Yes, sure. So SMB has been a headwind to growth for us now for a few quarters. We have found that this is a segment that has had the most challenge in terms of higher levels of churn and downgrades. And I think it's consistent with what we see happening out in the market in terms of start-ups, small companies, which for us, a lot of SMB is start-up technology companies. We've had less access to capital. We have seen those companies often migrate into our free plan or land in our free plan as a mechanism for them to at least start using PagerDuty. We're not expecting the SMB market to suddenly dramatically improve. We think it will over the longer term. But for now, we're expecting it to be slightly challenging and we've factored that into our view. But our focus is certainly on the enterprise. Like how do we ensure that we can deliver success and deliver the guidance that we've provided and accelerate our growth through prioritizing the enterprise. And I think one thing, even though that I missed to mention earlier when we were chatting about this, Koji, is that in the enterprise, we've seen not just the multiproduct but the multiyear focus, right? And we've seen customers are now committing to us for a longer term, which is important because it represents their commitment, which makes us invest in that commitment. And it's even reflected if you look at our recent disclosure from an RPO perspective where we started moving to reflecting both our billed and unbilled contracts. If you look at our RPO from Q1 of last year to Q1 of this year, the percentage growth in the items that were related to multiyear grew by 26%. So we can see that this prioritizing the enterprise is definitely getting our customers at least to focus on longer-term commitments with us.

Yes, that makes sense. Any questions from the audience? I got questions for you, Well, thank you, Koji. I got a quiet crowd here. I got lots of questions. So how do we think about the competitive landscape. We do lots of checks and DevSecOps and we always ask them about observability tools and other IT ops tools and then we come to incident management tools. And everyone always mentions, PagerDuty's brand. So congratulations. You've built a very strong brand out there with PagerDuty. So yes, I guess the question is how do you categorize the competition or characterize the competition? I mean there has been some consolidation in the space over the years. You do stand out from our checks, what we hear out there is very strong brand reputation. And so who are your competitors like broadly frame what do they look and feel like? You don't have to name any names -- and has that changed over the years?

Yes. I mean I always think about competition like in 3 buckets, right, in terms of how this plays out for us. So customers, they have 3 options. The one is that they may [indiscernible] their digital operations, they may cobble together a bunch of point solutions, right? And so that's kind of option #1. And that may end up having a level of effectiveness. And they may have a different solution for automation to what they have for AIops to what they have for incident management. or you have customers who end up trying to manage their digital operations through homegrown solutions and maybe using some aspects of some other larger platforms that they have acquired, and they're trying to use manual processes plus some homegrown together with that larger platform. And then the third option is PagerDuty, which is kind of you can have all of this integrated into one platform, and we are the only company today that is able to offer you the incident management, the AIops the customer services, the process and workflow automation in a single integrated platform, right, and go all the way through that cycle of detection to order remediation to analysis and learning. So when you look at it that way, we tend to then be competing sometimes with point players who have got point solutions, sometimes with homegrown or a lot of the time with homegrown solutions that sometimes leverage a larger platform or some characteristics of it. But ultimately, we want people to focus on the integrated operations Cloud Platform. Yes.

Last question for you, Howard. Thank you so much for doing this. You are the CFO, so I'm going to ask you the cash flow question. And you mentioned earlier in the conversation, you look at our healthy cash generation. So how do we think about free cash flow generation for you guys? How do we think about potential implication of cash taxes affecting free cash flow. Any sort of seasonality we should be thinking about with free cash flow? I mean conversion from operating income, all things factored into how do we think about cash flow because it does look very attractive for you guys.

Yes, sure. So we certainly have focused on ensuring that we have sustainable free cash flow. I would say that there's obviously some variance seasonality from quarter-to-quarter. It's not going to be even every quarter like this quarter, we saw high 20s free cash flow margin. We do expect that sort of moderates throughout the year. The way that we think about it is free cash flow on an annual basis, being a couple of percentage points better than our operating non-GAAP operating margin. So that's often a useful metric proposed to think about that. And we obviously are very mindful around thinking about the provision for taxes. And our most recent guidance has included some of the incorporation of those taxes.

We're all out of time. Howard, this has been awesome. Thank you so much for doing that. Appreciate the time.

Of course, thank you so much.