Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Well good afternoon. I'm Jack Andrews. I cover the data analytics and infrastructure software space here at Needham, and we're very pleased to have Ken Stillwell with us today, Chief Financial Officer of Pegasystems. So welcome Ken. Thanks for taking the time to join us today. Maybe just to sort of start off, for those who may be new to Pega, can you just provide a maybe a quick overview of the company along a couple of dimensions. One would just be your overall product set, the markets you serve. And then I guess the other dimension to talk about is we've been on a journey towards a subscription transition.

Sure, Jack. So we -- Pega started off in -- early in our history, we were the leader in business process management. And that -- for those that don't know what that encompasses, that was largely applications that were built to manage certain execution of workflows and using things like case management structures that we had kind of a industry-leading solution set. What business process management helped to do was it helped to organize a set of actions and activities that would go through a set -- a series of steps to execute an outcome. Typically that involve touching other systems, systems of record, and this would commonly be used for a type of activity that might transact through a number of systems through the life cycle. We -- that exact example of a set of workflow or automations that happen through disparate systems to execute an outcome is the same activity that happens in what's called the CRM space. When you're dealing with clients, they go through a selling channel, they go through a marketing, set of activities. There's places where they interact through a service channel. And at the same time, they are actually, in many cases, the clients -- our clients are using operational information to interact and to drive those activities with the client. So CRM and what was formerly called BPM, really had the same kind of work execution style, which was to take things from different places to help execute work over a series of process steps. So that was an easy transformation for us to kind of transition, I should say, to go into the CRM space. So CRM and BPM typically are referred to as front office and back office. BPM is now called digital process automation, which encompasses things like robotic process automation. It also leverages a lot more AI than what was traditionally used in kind of the 10, 20 years ago of BPM. So over that time, our business has transformed as well. It went from what was a heritage perpetual license kind of model and it moved into more of a subscription model. And that's not -- when I say that it moved the market, the demand environment moved into that because customers wanted to buy on a subscription model, and more recently, on a cloud model, on a SaaS model. So Pega's transition really was being driven by the market. Our clients were really saying to us, we want to buy on a subscription. We don't want to make the large upfront investment like we used to on a perpetual license. And additionally, they were moving more towards a public cloud, a SaaS offering. So we really didn't have a large SaaS or Pega Cloud business 4, 5 years ago, it was actually quite small. In fact, I started about 4 years ago when I started the Pega Cloud business was somewhere around $25 million a year-end revenue or ACV, now it's approaching $200 million. So it gives you a sense of the growth rate that we've seen over the last few years. So that's been quite an exciting journey to not only move from the back office into the front office and also to move more to applications to continue to enrich what we sell to our clients. And more recently, in the last few years on -- as our primary go-to-market is Pega Cloud, which is our SaaS offering. So it's been quite a fun ride.

I appreciate the overview there.

So let's turn to sort of the common -- the most frequently addressed rush I should say, [Audio Gap] in order to respond? And then how should we think about how exposed you are to maybe some of the more impacted industries these days?

Yes, great question. So when we first decided to ask employees to work remotely, which was for us some time in the beginning of March, March [Audio Gap] something like [Audio Gap] we would be able to function [Audio Gap] et cetera. So I was unsure of what that would look like. I was also unsure of our clients that how our clients would interact in that way. But what I'm pleased to say is that not only did we peg up, managed through that [Audio Gap] I actually think we're [Audio Gap] between individuals at Pega across geographies much tighter now than it was before. I mean, we rarely had international calls where people's video was our example. I mean, it really wasn't -- that wasn't quite yet the culture of companies like Pega to people would call in and some people had their video on. And it wasn't really now everybody is so accustomed to it. It's so [Audio Gap] kind of a really good kind of collaborative and team building environment to see people feel connected. I'm just -- I'm amazed at how we've responded, but what's even more shocking is how our clients have responded. Our clients have just, I mean, really just not missed a beat. I mean, they have -- I really am quite proud of some of the companies that we do business with and how they've just stayed committed to their purpose through this, not only committed to their purpose of engaging with vendors like Pega, but also the mission that they have with their consumers, with their customers, with their constituents. So it's been -- it's really been wonderful to see. I think the industries that you would typically see most impact industry that are not the most common industries that Pega operates in. For example, hospitality, travel, transportation, the airlines, even manufacturing. None of those are our largest or more prominent industries that we've sold to. [Audio Gap] financial circulations, how funds have done, are performing very well and probably less immediately impacted. But we'll see how things play out over the next year or so. But I do think that our industries have held up. And also, we're selling to larger clients. We're selling to the best and most well-respected brands in the world. They tend to be [Audio Gap] that capital structures that they can withstand some of the challenges of an environment like this.

Right. I appreciate that. And so just to put some numerical parameters around it, you haven't changed your guidance for the year based on what's been happening. So how should we think about that? What are the implications of that essentially?

So we've had a hit of providing guidance at the beginning of the year and not commenting or updating guidance through the year, except to the extent that we actually did something like an acquisition or something that would potentially be an obvious reason why we would adjust guidance. So we're not going to commented on guidance. That's not to say we have not reaffirmed it, we have also not adjusted it, withdrew it or commented. It's our policy to just release guidance at the beginning of the year and then do our best to meet or beat that. What I would say is that objectively, it would be difficult for me to argue that there's not more downside pressure than there is upside opportunity in today's environment. I think that's for pretty much all of us in any type of a recessionary environment. That said, the point that I made earlier about the industries that we operate in, the clients that we are working with, coupled with the fact that digital transformation is never going to be more important than it is right now. And so I think that of all the business models that are out there, I do think PET is well positioned, not only to do well in the middle of this, but also on the other side. So I'm really excited about our opportunity.

I appreciate the context around that. So wanted to talk about how should we think about you've got an upcoming opportunity related to subscription renewals. And so how do we think about -- you provided a fiscal '22 revenue target. How much of that sort of was related to this renewal opportunity? Could you sort of frame that situation for us, please?

So naturally, in a recurring environment -- excuse me, in a recurring business model, your existing clients and the retention rates are a very, very critical piece of maintaining your growth rate. So when you look out to 2022, 2023 and look out a few years, we're going to -- our business is going to be almost exclusively recurring. And with that, about 2/3 of our business that we do with clients each year are with our existing clients, meaning that we are up or cross-selling or expanding the opportunity that we've established with that client. So I think the combination of our business being almost exclusively recurring and the fact that we get a lot of our business with our existing clients and our very, very high retention rates, I think that there will be -- when we get out to 2 or 3 years, you're going to have much of the revenue that actually is coming into a year will already be built with the relationships and the business that you've closed prior to the start of that year. Even in this year, when you include our professional services, we're approaching 90% visibility as we enter a year. And I think that number will just continue to grow, to eat higher as we actually go into a full recurring business.

Okay. Great. You referenced cloud earlier in the overview of the overall company. So I'm going to drill down on that a little bit. How are customers thinking about running Pega Cloud versus running in a public cloud provider versus maybe in their own data center, I mean, what are some of the drivers that push customers in one direction or another?

Great question. So I think clients wanting to operate in their own data center has really been driven by their history of doing so. And the fact that they have resources and capacity to manage those data center activities, I do think you're going to see less of that. I think that it's obvious that when you have disruptions to people's work patterns, it highlights areas of risk at an area of risk for our clients and quite frankly, all companies is this reliance on a data center. You may or may -- your employees may or may not be able to get to, right, depending on if you're an essential business or a nonessential business, and so I think that is a risk that companies need to manage and then prepare for us. I do think the data center world will -- it will go away over time. And what we will be left with is public cloud or private cloud. Private cloud is essentially a virtualized data center. If you want to look at it that way, right? It's -- except you're using a AWS or an Azure or a GCP as your infrastructure platform. And then you're going to have public cloud providers. Now we think that our clients will be interested in options, in choice, as we call it. And we don't see at the enterprise level in applications like Pega, clients accepting one or the other. They will -- we believe that clients will have very specific needs. Now to follow-on that question that you asked, why would somebody want to use, say, a public cloud versus hosting on one of the larger private cloud environments. Primarily, it's driven by the level of acceptance and skill set and other environments that are already running in that private cloud environment. If you have a client that has a significant expertise and has history and has built a very efficient private cloud environment, they're going to be more likely to want to add certain applications to that environment. But other clients have not really built that level of expertise. They actually have a strategy to rely more on public cloud vendors. So I don't believe it's a differentiation in the product or the offering. And I don't think one is easier to operate or harder to operate. I think it's really a preference about whether your strategy for how you build your technology infrastructure is really predicated on a private cloud or more open to share public cloud kind of APIs and a little bit of a less, a thinner kind of private cloud architecture.

Sure, sure. Got it. No, that makes a lot of sense. So thanks for that. So I want to shift gears a little bit and talk more about some of your sales investments you've been making. Over the past few years, I think you've roughly doubled your headcount in terms of your sales capacity. But just if you talk about are things growing, are they ramping as you expected? And where do we think about the incremental go-to-market investments that you're -- you may be targeting these days?

Yes. So we made a decision a few years ago that we were not investing enough in growing the business. And that primarily was the investment in our selling capacity. So we made a change, and we accelerated and made it a more consistent push to hire the types of talent that we needed to help to grow our ACV. With that move, there were a couple of things we had to think about. The first one was, do we have an offering that can gain the kind of market share that we desire to have. And we're very comfortable that our offering is the best out there. And if you look at the Gartners and the Forresters of the world, I think everybody would agree that Pega is best-in-class. That was point one. Point two was can we hire the right people? Can we hire the people that have the vertical expertise that understand how to engage in the way that we need to win with our enterprise customers, that they actually understand the space that we're in or are excited and really would be effective in selling in that space. And then the third one was, can we actually enable and manage and scale that out at a faster pace. The first 2, whether our solution is competitive enough, or best-in-class and the fact that we can attract people, we have no concern about that at all. The third one is really execution, right? Can we actually get these new resources and get them enable, get them building pipe, get them closing deals and being productive. And for our business, that doesn't happen in a 30-, 60- or 90-day window. That does take some time as you build these relationships, as you build the pipe and as you penetrate, specifically in a SaaS environment where you typically sell a client and then up-sell and cross-sell them over time and expand that relationship. So that's really what we're in. We're in that journey of maturing those -- that capacity and really helping them all be a successful as our tenured account executives are. So that -- so we started this a little less than 2 years ago. And we are on that journey, and we've seen great pipeline build and really fantastic resources that we've added to our team. So we're really excited about this journey and starting to see some of the benefits of accelerating our growth.

That's great. So I wanted to just drill down one level back to your cloud business, in particular, and just talk about how does the sales investment, specifically on the cloud, the sort of driving the types of expansions and upsells that you thought that they would be initially?

We are -- we wouldn't change about our push to go into cloud, Pega Cloud and SaaS, except maybe we would have done it a few years earlier. I think now that we've seen the adoption of it. The investments, the thing with adding to go-to-market or sales capacity is that most of the really successful selling resources understand the SaaS market, and they understand the value propositions up. But because, quite frankly, a lot of the fast growth companies and technology right now do have a primary go-to-market like we do as SaaS. And so that's one point because as we bring in those resources. We have changed some of the enablement, some of the messaging, the marketing, even how we thought about contracting and dealing with our clients to really modernize to a SaaS offering versus an on-premise perpetual license. We've changed our commission plans a few years ago, right, where we got away from comping our sales teams on a total contract value basis, which is more traditional in a perpetual model to an annual contract value basis or an ARR measure, which is much more common in a SaaS company. And the great thing about that is as we've made that transition, we have not had a noticeable reduction in the actual contract duration that our clients want to engage with us. We still have our clients engaging with us kind of in a 3-year kind of is our standard model. And we haven't -- we've seen clients for solutions like Pega really view that as a sign of a long-term investment that they plan to make in their investment in Pega, and we view that as well because we're investing in that client, and we also expect to really help grow our relationship over time. And then the last point that I would make is we actually have focused on bringing in some skill sets, some specialist skill sets that actually really have come from some of the best and most respected cloud software companies in the marketplace to really help to bring some of that outside perspective of how some of these organizations have scaled and how they operate. So that's really helping to augment the Pega team with really as we continue to move on this journey to be a fully SaaS company.

Sure. No, I appreciate that context. So if we were to sort of wrap all this discussion together, I mean, can you share any sort of maybe rep productivity assumptions that could be built into your guidance over time? Just how do you feel about the sales capacity in place today to continue to drive 20%-plus ACV growth as well as potential margin expansion?

Yes. So we one of the biggest challenges that we have in the near term is we kind of have 2 things working against us in the actual financial reporting, that we -- the results that we publish. The first one is, we're going through this cloud transition. And for those that have been through in or for people like yourself that have seen it, you go from all the revenue upfront to all the revenue over time. It -- you do have a trough that you go through. So that transition, we're about -- we're a little bit pass the halfway point to that transition. But you don't really -- your revenue is suppressed until you really get kind of all of the years kind of stacked into your results. So that's, I say, point one, is we're kind of still optically in the midpoint or just slightly past the midpoint of this transition. The second thing is we added to that by actually ramping up our hiring. And when I talked earlier about the lead time for productivity for salespeople, we've actually -- in a time period where revenue is kind of accounting-wise, artificially lower until you catch up. And at the same time, we've actually ramped sales capacity, which you wouldn't get productivity until probably the following year that you actually hire. So we actually have a couple of things. And lastly, we also don't have a cloud business that's yet at significant scale. So our gross margin is not best-in-class yet on our SaaS product. So the combination of the 3 of those really create this very temporary situation where the sales teams will ramp and become more productive, which will ultimately drive efficiencies. Our cloud business will get scale, which will ultimately drive operating efficiencies. And we will transition through this accounting trough of the cloud transition. And the combination of the 3 of those will help us get to the kind of our Rule 40 target when we exit the 2022 year, which was our original long-term target when I first started kind of framing this back in 2017.

Sure. Got it. Okay. I appreciate that. So shifting gears a little bit. I want to talk about sort of how Pega plays into some of the newer emerging tech trends these days. As you alluded to at the outset, you have deep roots in the process automation market. You've got AI embedded into core of your platform. So can you just help us better understand how Pega is utilizing things like machine learning, predictive analytics and implementing this continually in your products?

Sure. So it's funny because Pega -- Pega's had an AI component to our product before AI was really a term that industry use. I mean we were doing our rules engine and algorithms that we had back in the early generations that Pega looked at patterns and trends and try to do predictive next best action type execution, really trying to learn from patterns and then predict what was likely the next thing that you need to do to support a client or the next step in a workflow that need to be executed. When we did an acquisition called Chordiant, which was a company that was a public company that was headquartered out of the U.K. that actually had a wonderful marketing automation solution. Their customer decision up, which was their AI engine, was just -- was really an excellent synergy with what we had natively in Pega. And so now after a number of years since we did that, it's been about 10 years since we did the Chordiant acquisition, not only do we have the best-in-class AI for enterprise workflow case management to be able to drive decisions and offers and actions in like lightning fast time, we're talking about thousands of decisions per second that clients need to make in digital channels. In addition to that, we've augmented that with our robotics solution that helps to automate the steps that need to follow from that AI decision from that decision. I've always said that decisions are only valuable when you can actually take an action off of them within the time that the decision is credible. Giving a decision that you don't action for 6 months, really kind of doesn't help like AI isn't really valuable, if you don't use it and you're not able to do something with it. And with our robotics and our decisioning, not only are we able to quickly capture the data, run it through a bunch of models, be able to figure out exactly what is the next best action, then take that action, all in a millisecond. And that's actually where the power of Pega is in the digital channel.

Right. I really appreciate that. I still remember the days myself when people weren't saying the only people making money from AI were those writing text books about how to use it. So nice to see some real tangible success stories around that. So the next topic is we hear a lot in the market about RPA, process automation. How do you think about that the ecosystem overall? And how do you think about working with some of these third-party automation and bot vendors, how that relates to what you're doing?

So RPA, I think, is similar to other aspects of the technology space, there's value in RPA. And when I say RPA, what I mean is the more modern version of what was commonly called screen scraping, right, grabbing some piece of data, OCRing it and populating it into an Excel file, into a system. It allows you to make a user be able to execute 20%, 30%, 40% faster in their day. So there's certainly value in that. And I think that there's lots of companies that will use that Pega has as an RPA product as well that our clients use. I think the challenge, though, with just that approach is it's limiting. It's limited to what you can see on a screen. It's limited to what a user can do. It isn't able to be done at the level of the process of the workflow that it may need to be done, which is embedded actually in the process as opposed to maybe just being more at the screen or at the visual. And so we think that the robotics space in general is a combination of a couple of those layers. One is being able to do that old, what we used to call screen scraping. We're able to do that. That's helpful. That's more like the Band-Aid of fixing a problem. But then you have the next step, which is how do you automate things? How do you skip workflow steps because you don't even need to do that step based on the learning that needs to happen. And also, maybe things that you know it can reroute the work in an efficient way, and the robot can actually help to send out a notification to a client, go capture certain data, right, maybe even through a text on a phone, right? These are all things that are like that next level. And then when you add AI, and you use the learning aspect of it. Now you've really built a machine, right, something that can use data capture through screen scraping when APIs don't exist, jump to the next step, which is to have it embedded in the actual work flow so that it's understanding the context of what the systems are doing and data structures that aren't even represented on a screen, all the way through to the decision models that can actually feed back to the robot to say when you see these things, you're self-learning and that robot is self-learning to figure out what I did yesterday may not actually be the right decision for me to do today based on what I've learned. That's where robotics, I think, has a fit in really automating end-to-end workflows of companies.

Right. Well that sounds fascinating. And so then the third area of interest is just the low code and no-code market really just enabling non-developers, great apps that can build workflows. So I'm curious what sort of customer interest you're seeing in these capabilities, especially as you enhance some of your platform functionality with things like Pega Express?

So we think there's value in 2 aspects of low code. There's the low code, what I call low code as a product, right, which is the actual capability to really quickly ideate and build some type of a quick application, not writing Java code or some other language and that's really what the Pega Express methodology really allows you to quickly build and quickly ideate and basically be able to get you something in days and maybe even weeks, not longer than that, to be able to show some value. But then there's another aspect of low code, which is I call it low codes methodology. Low code as an approach, which is not the technology as much as is -- it's not the actual low-code capability as it is the low-code kind of enforcement of saying, when I build something and when I evolve something, I'm not going to be forced to write code. I can take an application and I can evolve it. I can change it. Remember, things always change over time. I can actually add to it. I can connect to other applications, which, by the way, the applications may change over time, and all of that can be done in the UI of the product, right? It can be done by a business user that can execute that, not something that has to have code check-ins and writing more code and bug fixing and version control, all the things that are the problem when you write custom code. And so that's really where I think the low-code methodology or the low-code approach is so powerful. It's not just about being able to start quick and ideate because remember, any enterprise application that a very large company, like a large bank or a healthcare communications company, they're not going to build their enterprise backbone applications starting with just a sandbox of custom low code. They might get started to get the ideas. But when they actually go to build, they're typically going to use a platform that has a level of capability that they can actually configure and build on. And that's kind of where I think the low code is a little bit misunderstood because there's 2 aspects of it. There's the product piece and there's the methodology piece. And I think the methodology piece is much more powerful because it allows you to scale at critical size and be able to have applications never get legacy. That's the key, right? You don't want applications to get legacy. So then you have to go and swap them out. You want them to be able to -- you want them to be -- to build them for change.

Right. No, that makes a lot of sense. So just -- I was wondering if you could just touch on the significance of Project FNX. What is this new project provide that maybe you aren't able to do before?

So the simple description of Project FNX is take the power of what Pega has done with workflow in case rules robotics, AI, all the beautiful things that Pega does, but allow it, while each of those components to operate in the most efficient manner as possible and not be interdependent on allowing features to evolve and the individual aspects of the product to be improved. So one of the challenges is that when you build a product that operates so seamlessly with Pega, you don't want to be -- you don't want clients to have to wait to kind of evolve or upgrade all aspects of that product together, you want them to be able to have optionality to say, listen, I really want to take the new capabilities around what robotics offers. But I may want -- may not want to adopt the new methodology or a new model around rules. So it gives you that optionality to be able to have very tight connections, but yet the ability to still evolve in a really agile way. I use the example of -- it's like a home with fuse boxes, right? It allows you to kind of turn off a room and make the changes and turn the room back on, but the actual production environment continues to go on, which is really very -- and very much kind of -- it synchronizes and is consistent with a SaaS offering, right, with 0 downtime. So clients can almost build for change while they're in production with 0 downtime. And that's where you get the best of both worlds with Pega and FNX.

Right. No, I appreciate that perspective. So we got about a minute left. So maybe just the last question what we touch on was just your recent convertible offering. Just talk about how to think about that and some of the potential uses of cash there.

Sure. So when we first thought about the convertible offering, we knew we were going through a cloud transition. And just like we have the revenue trough, there's also a concept of financing the transition of going through a cloud, going from billing upfront to billing over time. And so we knew that we were going to need to finance this complete movement to a SaaS company. And we were -- we've largely done that with just the cash that we had on balance sheet and that we were producing from the company. But we knew we had that last kind of finish of that cloud transition. So part of the offering was to preserve some capacity to do that. It was also to be able to allow us through that to be able to look at opportunistic repurchases of Pega shares. And then lastly, we still want to have the option to look at some strategic acquisitions as we have over time. And what we're -- what I really felt was a great opportunity was because the convertible market with high volatility and low interest rates. The convertible market is just very, very attractive for companies like Pega, who have performed well and have a increasingly confident shareholder base that actually some of them have convertible funds as well. So we felt like there would be good demand. We actually went and started at $450 million. We upsized it to $600 million. But quite frankly, we could have went much, much larger than that because we had so much demand from our investors, which we were just thrilled. But we responsibly we stopped at $600 million because we felt that, that was really the right level for us to -- from a capital allocation. Now we didn't know about COVID when that happened. I mean, it was -- COVID was just starting to become a word in the middle of February, but none of us would have expected that it would have progressed and caused the disruption to some industries that it has. So now I look back and I think, wow, I'm really glad that I did that because it allows us to have that flexibility of continuing to execute the strategy of the business. And really be able to invest in the business as we move through what has been a -- for Pega, a very exciting few months, but certainly, for the market, in general, a very stressful one. But I think it allows us and we've been able to really continue to find and look for adding great talent to our team through that and also be assured that on the other side of this, when things get back to normal, then we will be well positioned to capitalize on the opportunity in front of us.

Sure. Great. Thanks for the color around that. Unfortunately, we are out of time, but I just want to say thanks for the discussion, and thank you for joining us today again.

Thanks, Jack.

Take care.