Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Good morning, and thanks for joining us today. I'm Jack Andrews. I cover the data analytics and infrastructure software space at Needham. Very pleased to have Ken Stillwell with us today from Pegasystems. So welcome, Ken. Thanks for taking the time to speak with us. The format here is we're going to do a fireside chat. But to the extent that anyone in the audience has a specific question for Ken, please feel free to use the chat function, and I'll try to incorporate it into our discussion.

So starting off, I want to start with you, Ken. Just congratulations on your recent promotion. You're now both CFO and COO. So just what does the addition of the COO role mean for you moving forward? How do we think about the bandwidth in terms of your responsibilities and your impact on Pega?

Sure. Thanks, Jack, and thanks for the invite. Happy to be here today. So when we started this journey to becoming a SaaS company, and I mean not just to be able to have an option, but I mean we really aspire to be a SaaS company at some point in the future. Right now, we still have lots of clients buying Pega Solutions on what we call client cloud, where we're not managing it. But when we started that journey a number of years ago, we -- I was deeply involved in the business model aspect of that, right? Thinking about how that would play out over the coming years, how we need to think about the operating model, the cadence, the margin structure, do we need to do something different with commissions? And that naturally led to the operations of Pega Cloud, which I took over in the fall of 2019. And then what -- kind of that was the natural progression to really help architect what is going to be the primary go-to-market model for Pega in the future. And as -- and our profit margins, our efficiency is going to be deeply tied to that business. And so over the last 1.5 years, I took on the cloud engineering team, the customer support team, the -- kind of the operations of Pega Cloud as a business. And then that naturally led to Alan asking me to take the COO role as well, which -- really, the way I think about what's different is I'm going to play a deeper role, making sure that we have tight alignment across the organization between what we build, how we go to market and how that materializes in the actual operation of our primary go-to-market, Pega Cloud, and so to make sure that I'm shepherding that kind of coordination. And then kind of my partner on the go-to-market side is Hayden Stafford, who will run all of the sales, the marketing, professional services, customer success, which is deeply tied to Pega Cloud. So we're kind of -- we've built this business out, architecting it in a product, go-to-market and in operational. And that's kind of where I fit.

Right. Got it. No, that's really helpful. I want to shift gears a little bit to your recent 1Q results. From our perspective, they seem pretty good in terms of the key metrics, Pega Cloud, ACV, revenue, EPS were all ahead of consensus. What are your key takeaways? What should investors know from your most recent quarter?

Sure. So Q1s are typically -- we don't -- most software companies like to say, don't get out to like a super-fast start at the beginning of the year. The way comp plans work, you have accelerators and there's always a lot of push for deals, both on the vendor side and on the customer side because of budget cycles. So I would say that Q1 started off, I would say, pretty much as expected for Pega. We knew that with a new go-to-market leader and really focusing on engaging with our partners to a greater extent and the way the shape of the pipeline looked that I had said when we gave guidance back in the end of the year, we kind of saw the year being the bookings and the ACV growth kind of being more tipped towards the back of the year, even more so than a typical year. So I would say Q1 was kind of as expected. I mean it was kind of another step in our journey to keep our ACV growth above 20% and hopefully accelerating and also this kind of getting closer to the end of the accounting transition, so to speak, of the messiness of going through a cloud transition from a perpetual company. So I think we're past the hardest parts of that now, and things are starting to make more sense in our income statement.

I appreciate that. I just wanted to drill into something you mentioned just a little bit more, which is the ACV growth. It was, I think, 20% year-over-year in Q1. How do you think about the potential to accelerate that moving forward? I mean what are sort of the underpinning drivers that investors should be thinking about?

Sure. So there's a few that I would mention. So the first one, quite frankly, is the sales cadence, the sales management discipline that we've -- we've made some progress on over the past few years, but I would say we still haven't really landed that in the way that we want. And I think Hayden is a major factor in driving that kind of that consistent, predictable sales productivity that we've often been criticized where Pega is not being as a productive selling machine as others in our space. So that's certainly a big one. The next one that's interesting is partners. We've really started to shift in the last 2 to 3 quarters of a complete kind of like -- a completely different way of interacting with our partners, right? It's really a more modern co-selling, leveraging joint marketing enablement, really a kind of a joined selling with our partners. And ISVs and the ability to do ISVs as the product -- as our product continues to mature in the future is going to be that next leg of growth that we could see in the coming couple of years. But I would say in '21 and '22, 2 big levers are: sales cadence and the management and the discipline and just the individuals that we've brought in from some of the companies that, quite frankly, we really respect their sales productivity that they've seen, and then leveraging our partner ecosystem and really helping our partners 2, 3, 4x the size of their Pega practices.

Got it. No, that makes a lot of sense. And I want to drill into those a little bit more, but just shifting gears back to the quarter for a moment. The other thing I would ask about was just Pega Cloud and the gross margins. You saw a nice uptick there from, I think, 60% to 67% year-over-year. So big percentage -- a big percentage point increase there. How do you think about Pega Cloud gross margins moving forward? Can you get these into the 70-plus percent range?

So I think getting to 70% is as close to a certainty as I have seen just because of the scale, right? I mean we're already at high 60s. The business is growing fast. There's a lot -- the incremental variable gross margin on a new deal of Pega Cloud, naturally, they're fixed cost. So we're going to get continued expansion. Now the question really is, Jack, how far above 70% can we get, right? Getting to 70%, I mean, we can see that. That's kind of maybe even the next exit on the highway, so to speak. Can we get to 75%? We certainly aspire to. Can we get to 80%? I would say, with a -- moving more towards a multi-tenancy architecture in the future, leveraging ISVs and really getting that much more kind of leverage, operating leverage as we sell incremental customers, that would be really nice to see. I'm not prepared to say that's going to happen anytime soon, but I certainly think it's in our future and certainly a potential. But right now, getting to 70%, I mean, that's something that we've made a lot of progress. And I feel like it's kind of -- it's right there in front of us. I'm really shooting for that, getting that up to the 75% range over the coming years. And I'm not talking about -- when I say years, I don't mean 5 years. I'm trying to get there in the next couple. And we have to -- certainly, we have to keep the growth rate up. We have to keep the operating leverage and continue to be efficient, and I think that it's in our reach.

Right. Okay. No, that's great to hear. And then I guess it was about 2 weeks ago now, you held your annual customer conference, PegaWorld. What are the key takeaways from your perspective from the event? What should investors know that was important coming out of PegaWorld?

So I think there was a lot more information around Process Fabric and how Infinity and our Infinity product and Process Fabric and Project fnx, as we've called it, which is the next evolution of our architecture microservices based, allowing multi-tenancy with still the value of data isolation for our clients and still the same level of focus on security, et cetera. I mean there's -- the evolution of what Pega used to be to where Pega is going is probably the most -- the least talked about exciting thing that's happening with Pega, right? Just the broadening the addressable market that we can go after as the product evolves and really making a move to a SaaS solution with not really that much disruption to our business in terms of the selling, the product, customers and really being the accelerant behind our growth. I mean that's a -- that was one big theme area that we talked about. And then the second one, of course, was partners. A lot of -- there's been a lot of investors very interested in our partner strategy. If you -- many of you who are listening have done channel checks with our partners. And I think our partners would verify that we are really engaging with them in a completely different way than we ever have. And we really view our partners' success being critical to our success. And our partners, I think, feel the same way. So I think those are 2 really big kind of takeaways for me.

Right. No, that makes a lot of sense. And so I wanted to just drill down into both of those. Let's start with the partners because, again, you sort of unveiled a new partner program. Can you just maybe flesh out for us the types of partners you've worked with in the past versus the ones you're targeting working with in the future? And then the related question is, how do we think about the impact on the business, call it, in 2021 versus the future impact over time?

So -- great question. So on the partner side, think about the first wave of partner engagement or with the partners that we already work with. They're already Pega certified that really have the opportunity to grow their practices of Pega significantly. The bigger SIs, right, if you just kind of without naming names, that -- think about those -- that cohort. We've got -- we're going to start doing more joint marketing with them. We're going to share opportunity information, even in some cases, do joint selling. Maybe we do -- maybe we did jointly as well even more than we did in the past. We're really making room and encouraging our SIs to get in front of that so that they can own that implementation and deployment relationship with our clients, which is the exact business that they're in and the business that they want to be in. And that isn't who we want to be, right? We value our professional services and implementation teams at Pega, very talented. We probably have the most talented people in the industry, but we don't want to scale that business because we'll be a limiter to our growth in ACV. We need the ecosystem to be able to support that growth. So that's kind of -- that's like the first phase. The second phase, of course, will be new SI partners that will be much more willing to engage and invest in growing their Pega practices in regions, potentially in verticals, in different segments of even our core verticals, where we don't have necessarily the coverage that we'd like to with our partner community. And then that last phase is what I would call the ISV phase, right, which is the one where people will use the Pega platform to build specific applications that are customed to a use case, a vertical, something that is a domain expertise for those ISVs to be able to leverage Pega. And Pega will be -- in some ways, they're white labeling, so to speak, the Pega platform and capabilities for the use case. And really, the way that we make that efficient is by leveraging microservices, having everybody on the same version, the multi-tenancy on the back end. Those are all things that allow an ISV to be able to sell -- they don't have to sell $500,000 or $1 million-type customers. They can actually go to a common use case with smaller customers and a larger cluster of them and still make that economic for us and for the ISV.

Right. No, that's helpful. So if I could just kind of summarize and put a fine point on it. It doesn't sound like you're really reinventing the wheel here. I mean you're sort of marching down a path that many other software companies have gone down. And so it's sort of -- it really comes down to execution. Is that kind of the fair way to think about this?

I would say that there's nothing in there that I would disagree with. I would say that -- to really even put another finer point, I would say we probably should have been doing this for years, right? This is the way that our SIs wanted to engage with us. And we really didn't engage that way in the past. So I would say some of this is probably something we could have and, in hindsight, probably should have been doing in the past. But regardless, our SI and the partners that we've talked to are super excited about the engagement level.

No, that's great. And so the other thing you've kind of hinted that I want to explore a bit more is just you've been talking about Project fnx. Can you just update us in terms of -- for those not familiar, what is Project fnx? How -- what is the impact on Pegasystems in terms of just your products and your ability to engage with ISVs?

Sure. So Project fnx is -- the approach and strategy for Project fnx is really moving and transforming the way that Pega's platform kind of operated as being more unified, but also tightly connected platform to something that is still unified, but built on a microservices architecture that allows -- easily allows a client or Pega to be able to continue to release new capabilities to that solution every week, every month, every -- whatever the frequency is, to be able to get new capabilities in the hands of all clients and not be in that kind of pattern of the traditional kind of upgrade and -- release and upgrade process that happens with more traditional software. So we're moving to, I think, true as-a-service architecture. And with that, we want to leverage the fact that we can provide so much value with the data isolation of the single-tenant solution for our enterprise clients, which is really an important differentiator, but also leverage multi-tenancy everywhere we can to be able to allow our clients and Pega to get that efficiency, right, where needed. So I think the key for this is everybody on the same version, always current, and the ability to really get an efficient cloud architecture, while not losing the ability to have clients have their own unique configurations and flexibility that they require for enterprise use cases.

Got it. And then just could you speak to the timing of this? How long have you been working on this? And when do you think this will be completed?

So we've been working on it for probably the better part of 2 years when we really started. I would say, in earnest, probably about 18 months. And we're getting -- we're well past the halfway point. And so you should expect to see something from fnx kind of releasing here sometime probably in the 2022 time frame. You asked a question earlier, Jack, that I didn't -- I actually just -- you reminded me with that question. We see partners influencing the back half of 2021 because if you think about engaging with partners, it really just takes a sales cycle to really change that behavior. When you think about fnx, think about fnx really impacting '22 and beyond in terms of the impact to the business.

Got it. Okay. No, that's helpful. And just one last thing on fnx is you just talked a lot about SI partners in particular. When we think about fnx, are there sort of technology integrations that may help you that you haven't historically been able to capitalize on with, call it, other cloud-native technologies that you might be able to plug in more easily? Or how do you think about that aspect of things?

So we always need to consider the value of having APIs with all the most commonly used software tools that are out there. I would say that we integrate with so many now that's -- I would say we have a pretty robust list of connectors with lots of the kind of the common places that you would connect, the SAPs and the Oracles and the Salesforces of the world. So I think -- but I do think having a more open architecture that is modern with the microservices bridge I mentioned before will certainly allow us to have tighter and easier integrations to maintain, right, with the more modern, kind of cloud-native vendors, which we still do have lots of integrations with those as well. But I do think that will be an important part of our -- to be as open and to have the flexibility of connecting with pretty much any system.

Got it. Okay. No, that's helpful. So shifting gears a little bit, just maybe speak broadly about the demand environment. It seems like everybody, including yourself, has been talking about how the pandemic has accelerated digital transformations for pretty much all organizations across the board. Just what are you seeing out there these days demand-wise? And is this sort of acceleration really sustainable here?

So the good thing for us is that we didn't see much of an impact from COVID. I mean we had impact with our employees. We had some of our clients, but many of our major industries didn't slow down their digital transformation. And in some cases, they sped them up. So I would say, in general, I would say 2020, we were blessed by it being a year that probably looked like COVID didn't happen for some of our verticals. Now what does that mean for 2021? I would suspect that many of those verticals that didn't really take a pause in 2020 will probably continue at a similar pace in '21. But there will be some verticals that would have a potential to rebound. Now I would say most of our verticals didn't have a big drop-off in 2020. So I wouldn't expect some huge correction, so to speak, in 2021. So I don't think -- from a COVID reopening standpoint, I'm not sure that Pega will see a tailwind from that. I think we'll probably be fairly neutral to maybe slightly positive as things get back to normal. Naturally, all of us will be better when we get back to normal because we're all kind of connected in the value chain. But I would say for our core verticals, I think they'll probably be continuing at the pace that we saw in 2020.

Got it. Okay. And then shifting to go-to-market, it's been roughly a year since you hired Hayden Stafford as President of your Client Engagement. Can you just talk about the business -- sorry, the impact that he's had on the business so far and how you see his impact moving forward?

Sure. So I think probably the -- I'll start with the fact that Hayden has fit in kind of wonderfully into the culture of Pega. And that's often a lesser talked about topic about whether there's a fit, right? As you bring executives together, just that -- and I think he's got such a great diverse background in terms of where he's worked. He's got lots of experiences with, quite frankly, companies like I mentioned, that we respect, that it helps us just get a perspective of how we are different, the same, better or worse. So that -- from the standpoint of just getting kind of an outsider's view of us, really helpful. We have the added advantage that Hayden actually competed with us as well, right, the actual business to be managed. So he actually has very specific information around like how does the market perceive Pega? How does the market perceive the competitors? How can we use that? How can we correct some of those misconceptions that the market might have of us? Or quite frankly, leverage the differentiators that are -- have been our success? So I think the outside-in view is tremendous. And then I think -- I'll touch on 2 more things, partners and the fact that Microsoft, I believe, does something like 50% of their business with partners, I think, is what they disclosed. And that's a really partner-centric, a partner-first kind of organization. We aspire to look to be similar in terms of our ability to engage with partners. And the last one is just the discipline, the operating discipline. Hayden is a very organized and disciplined sales leader. And I think that he wouldn't have had the success he had at other companies and which he'll translate to Pega if he wasn't. And I think that just -- that's something that's really great to see play out, not only with how he executes but how his team does. And that's the -- like I mentioned before, that's our most important lever at Pega. We've got the market. We've got the solution. We even, in some cases, are starting to get the brand, right? People are starting to recognize a little bit more who we are. We just really need that fire of execution. And I think that's where we see Hayden really helping us a lot.

Right. No, that's great. Then can you just sort of update us in terms of how you see the competitive landscape these days? I mean who are you running into and who might you anticipate running into down the road?

So we run -- we're still running into the same main 2 suspects, Microsoft and Salesforce, in all our core verticals. We see -- we hear lots of other companies kind of in and around our solutions. I would say the most -- the company that is similar to us is ServiceNow. Not similar from a breadth of solution but similar in terms of the way they talk about workflow and the way that -- so I think that there is similarity there. I would say we do see them not anywhere near as much as we see Salesforce and Microsoft. And then we see the vertical players, right? We see -- and we even see some of the newer entrants like the nCino and the Vlocitys and companies like that, that have come up over the last number of years. But I would say the competitive landscape is more similar than it is different over the last 2 or 3 years, Jack, in terms of who we see.

Right. Well, I specifically want to ask you about, I guess, maybe the low-code aspect and RPA vendors, which seem to be all the buzz these days. I mean is that -- do you feel that there -- obviously, you've got a very high-end elegant solution. So I mean do you see those at all? Or do you anticipate them potentially infringing on your market opportunity over time? I mean how do you think this evolves?

So we are -- I'll separate those. So low-code, I mean, Pega has been low or no code. We invented that space. It's kind of funny to see it kind of become a space that we've always -- we've always wanted it to become a space for years. But -- so yes, so low-code, I think we are squarely in the center of that. And so there are low-code use cases, where we will compete with an Appian or even ServiceNow and Salesforce are in the low-code space as well. So absolutely, that is core to what Pega does. On the RPA side, though, it's very different. I think there is a misconception that RPA leads to process. And it's not what we're seeing. We're seeing what -- I think the proliferation of RPA has really highlighted one thing, which is, man, there are a lot of companies out there still using Excel files to copy and paste data from, right? And that isn't -- I don't believe that companies are going to start to say, "Hey, I like this RPA stuff. I want to start putting more stuff in Excel files." I think there's just debt that companies have from a technology standpoint of how they capture data and where they move data that RPA plays a role in that. And we see that, and I think that we have a tool for that as well. So I do think that, that is a market that is real. I don't think that market naturally progresses into executing work across a complicated or even single-step workflow with integrations to other systems. The concept of copying and pasting is very different than actually managing an activity with data, with context, with integration and actually decisioning, right, actually understanding what we need to do. So I think that there's leverage of RPA in certain use cases. And there's leverage in robotics in the workflow, which is very different. But there isn't an evolution that RPA leads to BPM that leads to digital transformation. That's not the way that I see it. Now granted, anybody can build a new solution. But I think that there is -- kind of because the use cases kind of sound like they could kind of evolve to each other, which is very reasonable, it's just that they don't. And that's, I think, the thing that's probably the biggest disconnect on RPA to digital transformation.

Right. No, that's really helpful. And I just want to ask -- because I keep getting the question more and more of Pega versus ServiceNow. And I think part of it comes down to I feel like you have similar messaging. I think Alan has referenced Pega as a platform for your platforms. And I think Bill McDermott of ServiceNow has talked about the platform of platforms or something like literally the language has become very similar. And when I think about, again, sort of overlapping customer bases, I think you would argue that you're doing much more sophisticated workflow aspects of things, infusing AI in the decision-making process and things. But could you just maybe parse out beyond that, what is really different in Pega versus ServiceNow? Because as you alluded to, there is some similarity at the high level. But if you could maybe break it down a little bit in terms of tangible examples of how you're really different?

Right. So -- sure. So if you think about a use case that would be very common for a ServiceNow, go to their ITSM heritage. It would be an open/close ticket. Open a ticket, I need a new keyboard for my desk. It goes to the help desk for IT. They deliver it. They close the ticket, right? That's a very common one or maybe 2-step workflow process. You're probably not going to hit another system. And if you do, it might just be sending information like let me go to the inventory system to pull a keyboard to get to somebody's desk. So that's a use case that Pega could execute as well. But when you think about the use case of like, say, a loan origination, where you have to go to third-party systems, you have to use decisioning to actually look at the rules logic and figure out what do I want to do with this person based on the information and where do I want to route it? You might need to skip steps. You need to aggregate data across multiple cases to be able to figure out and learn what's the next logical step. And you also need to automate. You want to kind of automate the steps to get a human out of potentially managing a step so that you can really push scale transactions through an automated fashion. So I think the real-time automation, the decisioning and the importance of all the integrations with all the other systems to be able to keep that context of the case of what's happening so that you can actually do QA or do analytics or to be able to kind of learn from it, that's very common. If you think about that, that's any customer application, any customer transaction, underwriting, loan origination, onboarding a client in health care, like upgrading a cell phone plan. These are all things that sometimes are just a couple of steps. Sometimes, there are many steps. And I think that's very different than kind of the traditional open/close ticket kind of model. And so that's kind of where I think we have to differentiate. Like we are -- we don't -- we can certainly bid on the -- or try to win the open/close. It's just not -- that's not really the value of our solution. And so I think there's -- they're very similar. They're both workflow. They're just different levels of transactions and volume and kind of connectivity to other systems.

Got it. No, that's really helpful. And then you're -- coming up, I guess, a few weeks from now, you've got your annual investor session, I believe, is scheduled for, I think, it's Thursday, June 3. Can you just -- any previews you can provide in terms of who's going to be there and what we should be expecting to hear from this?

Sure. So I'm going to give everyone a little bit of an update -- or I'm not going to, but someone on our team is going to give an update on the product and kind of where the product and -- really to think about how we fit into low-code and how we think about kind of some of the themes of Process Fabric and including things like process mining and other things. So that's kind of one section. Then I'm going to give everybody a chance to hear from Hayden and even ask some questions as well from Hayden around the go-to-market, how he's thinking about it, where he thinks he is in that process, some of the outcomes that he expects to see. And then I'll do a kind of a refresh on our long-term kind of targets and how we're thinking about the model and what we think of the business now versus the last time I gave the update, which was last summer for our Investor Day, which is pretty -- I've been kind of in that cadence of doing that every year. So that's going to kind of be the flow. And then we'll have some Q&A at the end of that. And we're looking like we may actually be in the same room when we do this in terms of our internal Pega team with the new guidance in Massachusetts. So we're hopeful that we're moving ahead.

That's great. We look forward to seeing that for sure. So maybe just to sort of summarize here. I mean the most common question that I get these days from investors on Pega is just you've got a lot of macro tailwinds, again, around digital transformations. You have a very strong product. And so I guess, really, the question is why aren't you growing faster? I mean that's kind of the sort of -- one of those proverbial high-class problems to have, but that literally is the most common question. So what's kind of your response to that? I know you've talked about an acceleration over time coming out of the cloud transition. But how would you sort of answer that question?

So -- I've heard that a lot, and it's a completely legitimate question to ask. I think there's a piece of Pega's business that -- and our differentiator that I think maybe gets lost sometimes in the -- I think, first off, there are always going to be companies that grow faster than you, just like there are that grows slower than you. I think that many of our investors look at our product and look at our company and see the potential and see other companies growing faster and naturally want us and are rooting for us to aspire to that level of growth. Look, we've got to 20% off of what was 13% to 14% a number of years ago. So we've made that first step. I think we largely stabilized the growth rate over the last 2, 3 years. It's kind of that 20-ish percent number. I think it's important to understand that we have a very high retention rate and we're selling to enterprise clients. Our job or our goal is not to go out and just win as many new logos at any cost and then have churn or turnover or -- and so that isn't the business we want to be. That's not the business that we are. So I think we just -- our growth has been not as fast as we'd like to see it with the investment. However, I do think that we have to be careful that we don't try to chase clients and opportunities that aren't really the fit for what our differentiators are. And I think that, that is something that every company struggles with, but we just need to be thoughtful about how we get to that next tier of growth. And because like I said, we're a very high-retention business. And we want -- and we get a lot of upsell from our existing logos. And so it's important that we have success with our clients. And so that has slowed down, I think, our kind of aspiration of trying to really grow super-fast when you have to balance this -- leveraging your differentiator. So we're working through that. But I do think there's an opportunity for us to grow certainly faster than what we've seen. But I also try not to get distracted by companies that don't have the same business model as us and may happen to be growing faster at any point in time. So it is interesting, but it can be distracting.

Sure. No, completely understandable and appreciate that. I think we got just a couple of minutes left. So I mean, is there anything else that it's important for investors to know about Pega that we haven't necessarily touched on or addressed in this session here?

I think that many investors don't appreciate what Pega has and kind of -- I'll frame it in like a minute, right? We are a leading technology vendor. Look at any of the third parties and they can validate that, and probably the most sought-after software space with the brand names of all the largest companies that everyone wants to sell to with robotics, with AI, with low-code, right? If you put that all together, we have a pretty interesting position with the solution, the market and the customers that we already have with the very high retention rates. And we're making -- and I think we've managed this evolution to becoming a SaaS company reasonably well. So we certainly didn't break anything as we actually went through that transition. So I think the opportunity for Pega in the future is really going to be fundamentally leveraging what I just said are kind of the toolbox of value plays that we have.

Got it. No, that makes a lot of sense. Listen, I think we will leave the discussion here, but thank you so much for taking the time, Ken. Really appreciate the update and looking forward to the investor session in a couple of weeks.

As am I. See you, Jack.

Yes. Take care.