Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Great. Hello, everyone. Thanks for joining the Pegasystems session. I'm Dan Bartus from the enterprise software team here at BofA. Hopefully, you're getting used to the format. It's going to be 35 minutes of Q&A, and I encourage you all to submit questions through the system. I'll try to pick them up and address them as we go along or save some time at the end for any audience questions, too. So with that, I'm thrilled to have Ken Stillwell with us. Ken is the CFO and COO of Pegasystems. So Ken, thanks for the time, and welcome.

Thanks, Dan. Appreciate it. Glad to be here and speak with you for a few minutes.

Great. So first, maybe we can start high level. For those a little bit less familiar with Pegasystems, you guys have been around for decades, changed strategies, of course, periodically through that time. So when you look at -- back at how the company has reinvented itself into what it is today, can you walk us through some of the key milestones or how you define Pegasystems today?

Sure. So without going into maybe 35 or 40 years of history, I'll kind of -- I'll touch on a couple of key kind of inflection points. We started off really more as a custom application/code company where we helped to build certain workflow systems for some of our earliest clients. And that evolved into us productizing certain aspects of that: workflow, case management to name 2 really important pieces. We always viewed a really important part of our strategy as really allowing a user to not have to write a code, but to use the user interface and the tools to be able to change the workflow in kind of a -- more of a kind of a tool bar-type environment. At the time, that was not as common, and I think we had hoped that this would take off in the '80s. And what really happened was more of a proliferation of lots of different code types and code languages. And even if you sit -- as we sit today, I mean, there's just -- it's almost kind of -- you can't even name all of them, right, and new languages are being created as we speak. So it's really -- went in the opposite direction in terms of allowing systems to scale. Now in the last couple of years, the concept of low-code has really emerged. And so what we've really always kind of focused on, which is this no-code, allowing people to build systems without writing code, is now kind of more mainstream. And it's taken a long time, but I think people are realizing when we build enterprise applications and we want to change them, we don't want to have to scrap everything or shut them down to add a bunch of custom codes. Very difficult to maintain, and they end up becoming legacy very quickly. So as part of that journey, we went from being a case and workflow, which was really BPM, and we emerged kind of into the CRM space in the 2012, 2013, 2014, partially as a result of an acquisition we did in marketing automation and partially because we were selling so much in customer service. And we never really kind of even, quite frankly, viewed ourselves as CRM in the early days because CRM was so associated with sales automation in its infancy as a segment. So that's kind of how we got into CRM. We bought a robotics company in 2016. So where we sit today is we have case workflow. We have the CRM applications. We have robotics. And we also have a decisioning capability that really was kind of was founded from our rules engine and our rules logics and also the acquisition of a company called Chordiant that we did in 2010, which had a wonderful decisioning engine. So we now sit as a platform that can solve both operational workflow process automation and also CRM process automation, leveraging robotics, leveraging AI. And that's kind of -- and all of it done in a low-code manner. So I think a lot of the market has started to come towards us over the last 5 years, and that's really helping our growth acceleration that we've seen more recently.

Yes. That's great. That's a really helpful overview to start. So maybe we can zero in a little bit on the customer experience and CRM side of things first. Just curious how you help investors kind of divide up the customer experience market. Where exactly does Pegasystems play? And where do you choose to partner with some other bigger adjacent platforms as well?

Sure. So one of the biggest differentiators, it's not the only one, but one of the biggest differentiators that we have is our ability to, real time, make decisions and help our clients make decisions in omnichannel digital environments. That could be on a web. It could be on an mobile device. Could be when someone's in a store or at a distributor location, either digital or physical. And our clients are continuing to need this ability to make a quick decision sometimes when -- many times when you don't fully know who that client or prospect is. So there's this environment, someone comes to a website, you may know who they are, you may know certain attributes, but you may not know everything. And you want to, real and instantaneous, milliseconds, make a decision that is highly predictable to connect to better outcomes. So that is one area where we are very differentiated. We, many times, will integrate with a company like Salesforce or we integrate with a company like Adobe or even Microsoft, which is -- which are all competitors of ours as well. But I do think the space has kind of emerged as a you must partner, you must integrate with all of your competitors to really be able to help our clients be able to kind of pick and choose what they use for applications, but still connect them in a way that they can execute work and execute decisions instantaneous or near real time in that -- in a kind of a workflow approach. So we find ourselves both solving the application, building the actual application that the client uses to do marketing automation. We also find ourselves being the platform that helps to execute where certain activities may be done in another application. That also helps with inbound, outbound, lead routing, and that's just marketing automation. We also do the same thing for sales automation as well as service automation.

Maybe towards the service side of things, I'm just curious, I mean, broadly, how would you define customer engagement? It seems like so many companies are talking about it. You have kind of contact center space. You have a lot of omnichannel routes for the customer as well. I'm just curious how would you define customer engagement. And where does Pegasystems also play versus kind of the contact center technologies? Or how important is it to control more of that communication channel with the customer as well?

So certainly, I think all of the application providers want to be central to the interaction between our clients and their customers. So I would -- I don't want to minimize that. Companies like Bank of America need to interact with all of their customers. And certainly, they want to -- when you're an application that kind of owns or helps the client own that communication, you are essential, and therefore, there's a value aspect of that. I think the important aspect of -- that we think of client engagement is when you're in a customer service environment, you want the ability to communicate or, from an AI standpoint, tell a sales automation system maybe what you might want to do around that particular customer. And also maybe connect to marketing programs, certain communications that may be either in-flight or could be planned as a follow-up to some of that interaction. When you're in a marketing campaign, you want to understand what a client is engaging in a service call. You want to understand if they're actually in a sales campaign. And likewise, when you're in a sales campaign, you want to understand what information they got either communicated to them through an outbound channel or something that they may have went to the website and researched, a video that they watched, et cetera. In real time, you want that in the sales channel. So the key is to be able to connect that client engagement across all 3 and not view them as discrete activities. You set your market, you sell, you service. Many companies think of those as being discrete steps in a life cycle, and that's really where you lose the opportunity to be able to kind of populate and share and initiate activity cross channel.

Awesome. That's really clear. That's helpful. And then maybe shifting gears a little bit. Robotic process automation, hot space. Maybe you can just help us define how does Pegasystems play in this space. And maybe how is your approach different than some others in the market like a UiPath, for instance?

Sure. So there's -- because there's so many disjointed applications, Excel files, databases, people still faxing documents or electronically scanning documents in, there's a need to be able to automate the information that comes in and help, in [ an attended ] way, a robot helping a data processing person be able to speed that processing up. We've seen our clients really struggle with this concept of unattended robots, meaning the robot just guessing on what to do. And the main reason is because the precision of that guess is very low. And you have to really ask yourself for each of the use cases, how much do you want to risk having only a 70% or 80% success rate in your interactions with your client. For some things, it's fine. For other things, like you wouldn't want to approve a mortgage loan where you shouldn't have approved a mortgage loan. So you have to be careful in terms of the use case. But there's that aspect of robotic process automation that I think will always be there because systems can never be perfectly connected to each other. But where the real value we see is automating within a workflow, within an application, within a system of applications connected through APIs where you understand not only what is shown on the screen or what might come in an e-mail or what might come in a scanned document. But you understand deals, you understand the logic of deals. You understand relationships, tables, connection between information and the database. So that when you execute robotics, you're doing it in an intelligent fashion. Right now, the challenge with just the traditional way that RPA is done is it's very unintelligent. It's very kind of Monte Carlo simulation or trying to OCR documents and kind of guess what's actually happening. But the reality is when you're trying to make instantaneous decisions and manage work, you really want to try to not just make a person 25%, 30%, 50% more efficient. You want to make things self-service. You want to take the human out of the need to actually interact with those workflow steps. So for us, it's -- both are interesting. We're focusing on the latter, which is the one we believe will withstand all of the modernization that's happening with applications. We think the first is a band-aid, but certainly not -- certainly shouldn't be minimized in terms of how much it can help our clients. So we actually help our clients with the traditional screen scraping-type RPA. But our strategic focus is on automating the workflow as much as possible, really taking out human interaction and making that -- using AI to judge how things should progress.

Yes. Yes. Great. Really helpful as well. And maybe you answered some of this, but I'm just curious how process mining is part of this. That's -- it seems like another hot topic adjacent to it. So maybe you can discuss, just as part of how you view this market developing over time, how is process mining part of it as well.

Sure. So just a -- I'll draw a little bit of an analogy to this to the -- when low-code started to become a little bit more of a buzz word in the last couple of years. We've been no-code for 35 years. So when low-code came out, we kind of were like, what does that mean? I mean we've been -- we're no-code. Is even that -- better than low-code? So we kind of -- we associate with the low-code space, but what low-code really means is you don't have to write code to configure and evolve a solution. And we've been bought in for years. If you think about process mining, we have a solution that we actually have been supporting our customers for probably about 5 -- I guess, about 5 years now, which is called Workforce Intelligence, which essentially is process mining. We're doing -- we're actually going out and watching transactions, actions, information on the desktop and really being able to tell when users might leave their computer, when they might -- how often they go to different websites, how they're transacting data. And that becomes a stream of data back. With our Process Fabric approach to really connecting as a dashboard all the applications, process mining fits right into that concept of being able to stream information and then really kind of auto discover different processes. So we think it is relevant. I will say that many of the process mining companies out there have a use case that is very narrow around supply chain and vendors and collections and bill -- like kind of ERP adjacency. And I would say that, that -- those are not irrelevant in terms of how Pega can help, but we think the process discovery and Process Fabric aspect of this, which includes process mining, has a much broader application across the workload. So it is relevant for us, and we've had pieces of this for a number of years, and we'll continue to build out our relevance there.

Maybe that's a great segue to -- I wanted to ask about Process Fabric as well. How big of a shift was this for you guys? I think the effort's about a year old. Maybe you can just talk about the idea behind it and how customer attraction has been related to it.

So customers are super excited about it mainly because our clients use us -- some of our clients use us for 500-plus different application use cases within their organization. And so what Process Fabric does is -- one aspect of it is it allows a user or a group to be able to see all of their activity across all of the different application environments where they might -- where Pega might be helping. And that was -- before Process Fabric, that was done many times with an internal portal or a custom dashboard that our clients would build to integrate that. Now with Process Fabric, clients not only can see all of their Pega activity. They can see all of their activity in all of their applications. So they can understand that a client was onboarded and the deal was closed at Salesforce, and it was sent to licensing in Flexera and then it went to Pega for customer support. And here's where we are. Here's the NPS score. You can see the entire life cycle of the client. And you can even see where breaks in the process may exist or where you might be able to make improvements to the process because of throughput challenges or customer experience. So this is kind of a way to see your kind of client environments' interactions as opposed to kind of measuring it in each of the different kind of life cycle stages.

Okay. Great. And then another product area I wanted to talk about was Project fnx. Maybe you can just walk us through what's the idea there. What's the strategy?

So an important aspect of Project fnx is really this evolution that was started a few years ago when we really went bigger with Pega Cloud, right? Pega Cloud was something that 5 years ago or so was, I would say, a not as commonly purchased option for our clients. We really went from what was 5-or-so percent of our bookings were Pega Cloud to now well over 50% of our bookings are Pega Cloud. And clients are adopting Pega Cloud at a 50-plus percent growth rate year-over-year. Tied to that is really this evolution of moving to a completely microservices, multi-cloud where we operate on any cloud that -- the Azures of the world, GCP, AWS, Pivotal Cloud Foundry, whatever the client cloud environment is, and really focusing on being much more kind of friendly in the multi-tenancy world. Sometimes using Kubernetes or tools like Kubernetes to be able to create virtualization, to be able to get scalability, but sometimes truly allowing our clients to be able to deploy -- and ISV vendors in the future to be able to deliver applications that are multi-tenancy with isolation of data for each client, or single tenant on the data, multi-tenant on the services. That's where we aspire to get to when we -- once Project fnx is completed.

Okay. Great. And that's a good segue into the ACV growth, which is -- it looks like it's getting stronger and stronger based on this cloud migration as well. So you made it clear in your recent investor session that you aspire for ACV growth to be beyond 20%. And maybe you can walk us through some of the key things that need to make that happen to accelerate the ACV growth going forward.

Sure. So ACV -- our ACV growth is our key measure, has been since we started this cloud transition. It's really the kind of the apples-to-apples view of how we're growing. So starting there, ACV, for us, is very, very similar to ARR that other software companies choose to use. So I view them as ARR, ACV kind of as interchangeable. So now the question is, well, we went from approximately 12% to 13% grower before we started our movement to cloud. Now we're about 20%. So in the last, call it, 3 to 4 years, we've made a transition to be a 5 to 7 percentage point faster grower. Now can we actually grow and add 5 percentage points to that 20% growth in the coming few years? That's what we aspire to do. How are we going to do that? Well, one is we're going to leverage partners more. And we started an initiative a few years ago, but we've really focused heavily in the last 12 months on enabling our partners, going to market with our partners, sharing campaign strategies, really co-selling, allowing them to be more engaged and have more ownership of the delivery aspect of this, which is really what our SI partners want to do. I mean that's their business. The second aspect of that is we wanted to really amp up the -- kind of the distribution maturity of our sales leadership. We did -- our sales leadership did a great job for a number of years getting us to $1 billion. And what we really wanted to try was to get to that next level, which meant we had to bring in leaders that had seen that growth rate at some of our competitors, some of our peers at companies that have seen scale much bigger than Pega. And we really wanted to kind of augment the team that we had with some of the new talent that we brought in. And then the last piece of this is really connected to some of the digital transformation initiatives and the big focus on digital transformation and low-code and the modernization activities that our clients are going through as they take legacy applications and they want to modernize their experiences, both internally and with clients, and Pega can help them on that journey. So I think that the market we're in is the fastest-growing enterprise segment. We're really focusing on leveraging our partners, who have completely committed to this segment. And we're augmenting the talent that we had with some really top-notch talent that has seen growth rates above the growth rates that we've historically had.

Great. Great. Great overview. So I just want to remind people, if you do have any questions, feel free to send them through. And so Ken, the Pega Cloud growth was very strong. It really stuck out to me. But I'm curious, is there any way to think about how much is coming from new customers versus existing customers migrating to that?

Yes. It's a great question. Very few of our clients are migrating to Pega Cloud as part of our growth. So I think that, that is an opportunity in the future. Almost all of our Pega Cloud growth are net new clients, net new clients or net new environments, solutions, applications, use cases for our existing clients. So I do think there's a tremendous opportunity, over time, that some of our existing clients will choose to move to Pega Cloud. And naturally, there is a markup. The clients will invest more in that because it is a fully managed service that we offer compared to the traditional client cloud. So I think there's a great opportunity. But all of our growth right now is coming -- the majority, 95% plus of our growth is actually coming from Pega Cloud new sales.

That's -- it's a lot higher than I would have assumed. Are you nudging clients at all to shift to cloud? Is there more you can do there? Or is it pretty much we'll have to wait and see and let them make that decision?

So we've taken a strategy of encouraging and educating our clients, but not in any way trying to force them. Many clients take an approach of defunctioning their non-SaaS product and force everybody to move to the SaaS product. We are not taking that approach. Our clients have invested a significant amount in the solutions with Pega, and we want to be respectful of the journeys that they're on and when they're ready. But many of our clients are coming to us and starting those discussions. And they started them toward the back end of 2020 as kind of the pandemic really hit, the reality of we do need to be able to have people working remote, which means some of our technology needs to be more modern, and we really want to rely on our vendors more with SaaS solutions. So I do think our clients are moving in that direction, and we are having more of those conversations now than we did 2 years ago. But they're not kind of sales plays that we're running as much as we're supporting our clients as they get ready for that journey. The interesting thing, Dan, is one of the most common times that people are interested, clients are interested in taking a Pega kind of client cloud solution and going to Pega Cloud is when they're also looking at expanding their relationship on other solution areas with Pega and tying in Process Fabric. So that's a really compelling event to kind of almost land a bigger kind of entitlement footprint of what they own for Pega in Pega Cloud.

That makes a lot of sense. And Ken, sticking with the go-to-market theme here, you've had a lot of changes on the go to market recently. Can you guys walk us through what needed to change and where are we at with a lot of those efforts?

So the -- we had, I would say, some success with growth just from hiring more capacity, right, just increasing capacity. That certainly works, but it's difficult to get -- to do that without getting the operating leverage. And even though our gross margin was improving for Pega Cloud, which is certainly critical as Pega Cloud becomes larger, we weren't getting enough of the sales productivity or efficiency just kind of adding capacity. So we knew that partners were one lever to be able to become a force multiplier, so to speak. We also knew that really bringing in people that had -- who could help us evolve some of our go to market, how to leverage account-based marketing, how to think about specialist sales teams around some of our solutions, how to think about the collective sales pod versus the traditional just AE and kind of sales engineer kind of go to market. Those are all really helpful things to be able to take what we've had that has gotten us to a level of success, we got to $1 billion using the existing structure, and now help us kind of get to that next, get to $2 billion, $3 billion, $5 billion, which we really felt would be harder or maybe easier to do leveraging some of the new kind of approaches and talent that we brought in versus trying to do it just kind of the way that we got to $1 billion. So we wanted to kind of balance both.

And you mentioned gross margins, and I wanted to ask you about that as well. So can you just kind of frame where are we versus your targets? What does the path look like to where you want to be? And I'm sure Pega Cloud gross margin is a big piece of that. Maybe you can drill into that for us as well.

Sure. So you're absolutely right, Pega Cloud is the key piece to it. So when we started this journey in 2017, we had Pega Cloud of $50 million-or-so of ACV with gross margin of like 40% to 45%. So that was 2017. If you fast forward to right now, we've got an approaching $300 million of ACV with gross margins in the high 60s. Where -- when I first set up some long-term targets, I had said that we wanted to get to 70% gross margin for Pega Cloud. Well, I think that given that we're so close and we've got so much success getting that margin up, I think 70% is probably inevitable in the next year or 2. So I've kind of recalibrated our target up to 72% to 75% because I do think that we can get to the mid-70s. And quite frankly, with Project fnx and some of the multi-tenancy, Kubernetes, et cetera, I think that we've -- 80% is probably in the realm of possibility as we get larger and we get out a few years. So I think right now, we're about 67%. I think 70% we can get to in short order. I think 72% to 75% is kind of that target over the next, say, 2 years or so. And some of that is just operating leverage because the business is growing. But some of it is the -- some of the evolution that we've done with both the product and the operations of our cloud environments to be able to get kind of continued operating leverage on the operating base of Pega Cloud.

Right. Right. I'm sure that answers a little bit of my next question. Wanted to ask about Rule of 40 because that was a big focus in your recent investor session as well. So maybe first, could you just help us, how do you define Rule of 40 for you guys? And just what gives you confidence that you can become a Rule of 40 company over time?

Sure. So Rule of 40 kind of goes back a long way for me, back to my heritage in private equity, back in the 2002, 2003 time period, where I did a lot of work and really evaluated companies on this concept of diminishing returns of growth, right? Before there was ever a Rule of 40, right, there was this concept of how profitable can you be based on certain kind of growth clips, right, or steps? And it turned into this simple calculation that probably happened in, I don't know, 2008, 2009, 2010, people started to talk about this concept of, well, if you added up growth and margin, what would you want to -- how would you -- what would you want to be at scale? And that's kind of where this Rule of 40 came from. So through my career, I've always kind of reinforced that concept of if you're not growing, you better be very rich in cash flow. If you're growing fast, you can give up the margin or the cash flow because you're reinvesting in the future of the growth. So for me, the simple way to think about Rule of 40 is our ACV/ARR growth rate and our free cash flow margin. And so when I first kind of -- when I first looked at the business in 2016 and '17, I thought we would have a business that was growing 15% to 17% that would generate somewhere in the kind of low to mid-20% free cash flow margin. That's how I would get to 40. Well, it turns out I was wrong. Our growth rate is now 20%, and we're really targeting getting it higher, kind of toward that low to mid-20 percentage range, which really makes it difficult to then have profit margins or free cash flow margins kind of up in the low 20s given how much you have to invest in the business, also how much of it's Pega Cloud. And there is an accounting lag in terms of when you actually be able to -- you're able to reflect that growth rate. And even some of the billings are kind of over time. So I think that we have to be realistic about it. We're growing 22%, 23%, 25%, that's really difficult to get at a sub $5 billion kind of revenue company. It's challenging to be Rule of 45 or Rule of 50 so quickly. But I think that we are -- we've got to kind of go on this kind of trajectory of continuing to keep our growth rate higher and getting incremental free cash flow margin growth. So that's kind of how I think about Rule of 40 and how I think it will play out for Pega.

Great. That's really helpful, too. I guess as part of that, I noticed in your recent presentation, I think free cash flow margin in 2023, you brought that down a little bit, expect 15% roughly margin. And I want to say from memory, it was more like 20% in '22 before. Can you walk us through how you're thinking about that, what that reflects in that updated view?

Sure. It's really quite straightforward. When we first set up our targets, which were the low 20s for free cash flow margin, we were assuming our growth rate would be more like 15% to 17%. Given that our growth rate as we exit the transition we anticipate will be much greater than 15% to 17%. It would be kind of more in the 20% to 25% range. We then calibrated our free cash flow margin based on that investment that we're continuing to make in the business as a faster grower and more of it being Pega Cloud.

Got you. Yes. It makes perfect sense there. And then looks like we have roughly a couple of minutes left. So maybe I'll circle back to one I glossed over earlier, and that's just on TAM. I'm kind of curious, you're moving to these new areas, RPA, process mining. I know you said you guys have been doing low-code for a long time, but low-code does look like it expands the TAM in some categories, too. So just how should investors think about the TAM? How do you define the TAM? Any kind of numbers you can help us with there, that would be helpful, too.

Yes. So I don't like to gloss over this question, but I do kind of gloss over it sometimes when I give an answer. So let me explain why I do. If you look at a company like Salesforce, they'll tell you that the market -- that their TAM right now is over $100 billion, growing to $200 billion, just round numbers, right? It's large. I mean they have something like 25% of the market share of the markets that they're in, right? So when you look at our markets, we're -- our TAM, we don't have the same addressable market that a company like Salesforce has. Remember, they're getting that data from IDC, from Gartner, from Forrester. They're not making that up. They're getting -- same sources we go to. So what we did, we went to those same sources that all of our competitors go to. But we focused on the organizations that we target, which tend to be the larger organizations in our core verticals. When you -- with just quick math, that kind of cuts the market down by 30% to 50% in terms of the TAM of what you might see from a company like Microsoft or Salesforce in terms of what they could address because we don't go down market, we don't sell to every single organization, we don't sell to every single vertical. So we try to be realistic about the fact that our TAM is something like $60 billion, $65 billion, $70 billion, growing to over $100 billion. Now the reason why I gloss over that sometimes is we're $1 billion, and we're talking about a TAM that's approaching $100 billion. So for us to double our business really isn't even scratching the surface on disrupting or cannibalizing the market. That's the reason why I don't get into a lot of science around sizing. It's so large that there's plenty of room for us to double, triple, quintuple our business over -- in the coming years. So I think we're -- that's really not the restricter. The restricter is us executing, right? We just need to execute well. I think the market is plenty big.

Yes. Yes. Certainly a sizable TAM there. So we do have 1 minute left and a question came in. So the investor is interested in, can you give us a sense of the scale you'll achieve by fiscal '23? I guess you had ACV and revenue targets prior, but no discussion of this at the recent Analyst Day. So anything you can help with there?

So -- yes. So I gave some longer-term targets that I think is really where this question is focused, which was I talked about ACV of $1.3 billion, and I talked about revenue of $1.6 billion. And that was back in 2017 and 2018. And I would say that the revenue side of this is probably a little bit -- a little -- when we get to the end of '22, we'll be a little bit short of that because of the percentage that's going to be Pega Cloud, and the fact that the revenue really doesn't come -- typically SaaS, it typically comes about 6 months out from when you book it. So a little bit of the revenue will be delayed. I think we'll be kind of within spitting distance, so to speak, of ACV and revenue when we get to the end of '22 and into the first and second quarter of '23. I don't think those top-level numbers are kind of materially off or different than kind of where we thought we would be. But I do think I'm trying to more focus in the kind of -- in 2023 on what does the model look like as we get into '23 and exit '23. And I think that whether we're at $1.550 billion or $1.6 billion or $1.650 billion might just be some of the timing of how the revenue comes in versus actually, I'm focused more on the growth rate, the exit growth rate of ACV because that, I think, is actually more important than just how the accounting shakes out.

All right. Perfect. Well, Ken, thanks so much. We're out of time. Really -- a really great session. I appreciate it.

All right. Thanks, Dan. Take care.

Take care.