Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Hi. Good morning, and thank you for joining us today. My name is Samad Samana, and I cover software here at Jefferies. And with us, we have Ken Stillwell, CFO of Pegasystems. And Ken, thank you for joining us. We really appreciate your time today and look forward to learning more about Pega and your own story as well.

And so maybe for investors that are newer to the story or may know less about it, it would be great if you could just maybe give us a brief overview of Pegasystems and what the company does. And maybe the main market that you guys are playing in?

Sure. So Pega started a number of years ago, and we were one of the kind of founding companies of creating the business process management space. We -- what business process management was, was it was largely work flow activities that were built inside an organization where other applications and other systems couldn't execute that work. So for example, if you had a mainframe system or some ERP system and you had certain applications and you wanted to be able to process certain activities across from one system to another, you typically would deploy what was considered to be a business process system. And so what happened was companies would build these systems and they would use them for executing certain types of activities. In the early stages, they were very custom. They were things that you couldn't buy an application for like processing an ACH in a bank between bank to bank through the Federal Reserve. So that would be an example of a system that there wasn't something off the shelf. As the market matured, process has moved into the applications. So if you think of CRM applications, you see the initial CRM applications of like sales automation didn't think about processing activities. They just focused on, let's just capture some data in some forms. And when you're ready to execute, we'll print something out and we'll walk it down to somebody else and they'll enter that information in. And that was even the case 10 years ago, even less than 10 years ago, lots of companies didn't think about process being the importance of process and automating process being not just as a kind of a patchwork application in your organization to being central how you execute work. The reason why that's so important is maybe obvious, but because of the amount of data that's moving between these applications, companies have reverted to building custom software or conversely, bidding data processing centers out there. So the human beings are looking at forms and retyping information between systems which is terribly inefficient. So Now kind of what Pega has evolved into is we went from a platform to business process to a platform that leverages all of the process expertise of workflow, managing case into the actual applications that customers use. And there were 2 very strategic acquisitions that we did that augmented our capabilities. One was a company called Chordiant in 2010 that gave us -- we already had an AI engine like essentially a rules algorithm that we could use as AI. Chordiant had an incredibly strong customer decision, which would do like instantaneous transaction models against consumers that would come to websites or go to certain transactions in a digital channel. So the next thing we did that was a company called [ OpenSpan ] where they were a robotic process automation company. We actually acquired them. We have the robotic -- we have an RPA tool that we can use for screen scraping and the like when you don't have systems that connect. But we actually took the core code and we integrated it in with our platform. So now what we have is this powerful end-to-end automation platform that has the workflow, the process, managing the construction of a case with robotics, with AI, all done in a low-code environment where you don't have to write Java code to actually evolve the application. So that's why we are relevant in places where consumers are the end -- the end customer is a consumer that you have. You have very high volume of transactions, whether that be impressions, visits to a website or actually transactions like processing transactions or onboarding people in the health care -- on a health care plan, et cetera. So the verticals we sit in, FS, comms, health care, insurance, public sector and some of the consumer manufacturing is where you see that very significant amounts of transactions that really need to be real-time transactions with consumers. So we went from something that was very custom bespoke kind of into more mainstream where that's where our competitive landscape has changed over the years.

Great. And you touched on competition. You touched on some of the company's key acquisitions. Maybe if we zoom out just when customers choose Pega, what do they see as maybe the key differentiators when they're debating between using Pegasystems and a different solution or building it in-house the solution themselves?

So there's a couple of levers that we have. One is the enterprise-grade scale. There are low-code applications out there that really just can't scale. They don't have the breadth to be able to integrate, be able to manage the work. That's one aspect of it. Another one is real-time. Because of the way that we structure the case, the actual container of information, we have the ability to store information from other systems so that we can real-time transact with the consumer and having integrations with the other systems where some of that data may start or end. And so that allows us to be millisecond kind of response time in terms of making a decision, for example. Many of the companies that we compete with can't come close to actually representing that. They might have a 10 or 15-second delay if they're lucky, some post in batch. So it's hours or days before they can transact. So that has become increasingly important. No one else has robotics embedded in the actual workflow, in the application interface. Most of the robotic process automation tools that are out there sit on the screen. So they're copying data off from the screen. But if it isn't represented on the screen, there isn't a way to know that, that exists. And so that's a big differentiator. And our AI tool, like there are companies that do AI. But when you think about the companies that we compete with in the enterprise CRM space and in the verticals, none of them have AI. They have kind of more, I would call it, advanced analytics. It's more a creating charts, creating relationships. It's not something that can drive the next best offer and next best decision. So I think that there's this end-to-end, there's the construct of the case, which allows real-time robotics and AI, a combination of all of those together is superior to anybody else in the market.

Understood. I think that, that was a helpful lead-in for the investors that are listening in. Maybe switching gears. I know the company had an investor update in early June. Maybe it would be helpful if we look -- if you shared with us for those that weren't maybe able to listen in what the most important messages the company was trying to deliver at that investor update from early June.

Sure. So there were 3 theme areas that we touched on. The first that we talked about was really showing investors just how low code we are at enterprise scale, meaning we can start in a UI with no code and create a concept of a simple workflow to execute. We can then create integrations. We can create data stores and data tables and common knowledgeable fields like e-mails and add that all in, all through a business analyst working with the UI. Then we can manifest that into channels. We can create mobile views and we can create tablet views and PC-versus-map views. We can create custom use for terminals that might exist for MRP or ERP solutions. So that's kind of how we've kind of we showed kind of we can start simple and scale all the way up into an enterprise use case, all in a 3-minute demo, right? We'll be able to show you how -- I think there's a little bit of a misunderstanding with low code. And low code is a solution in and of itself. Low code is a methodology of how you approach application evolution, if we wanted to explain kind of our view of low code. The second one is we got our new go-to-market leader, Hayden Stafford, who came in, in June of last year. He talked about the priorities that he has, the team that he's building, how he's thinking about taking Pega from a 1 -- from a slightly over $1 billion company to a multibillion-dollar company, leveraging some of the techniques that are commonly used in enterprise software. And then lastly, I gave an update on where we are in the cloud transition that we're going through. How -- about the increased adoption of Pega Cloud much -- it's growing much faster than I thought it would be 4 years ago when we started this journey. There's some interesting ramifications of that in terms of accelerating our growth, faster path to gross margin improvement, higher gross margin targets, and it's actually even evolved our product strategy to focus on having some multi-tenancy capabilities as we move to a microservices application environment for Pega to be able to increase the addressable market. So I think that those -- that was a really exciting day. It was virtual unfortunately. Hopefully, this will be the last virtual one that we do because we normally do this as part of our Pega user conference that we do in May, but -- and we actually did that virtual as well. Those are exciting. We talked about product, we talked about go-to-market and then we talked about the financial performance and kind of our longer-term view update.

I understand your fatigue of virtual events, and I look forward to hosting you next year in London in person. So you just gave us a lot of details, and I want to pull some of the strings. But I actually meant to remind investors, if you want to ask questions, there's a box on the right-hand side of your screen that you can actually use and the questions will come through to me, and I'll make sure to weave those into the discussion. So please feel free to interact in the conversation. But Ken, maybe pulling on some of the threads that you just gave. You mentioned accelerating growth and a big part of that is you got -- the company has commented on accelerating ACV growth beyond 20%. What do you think drives that acceleration? And maybe what are some of the key assumptions there?

So the -- what has driven the acceleration in ACV growth to date has been Pega Cloud. And I believe Pega Cloud will continue to be a big driver of that acceleration because Pega Cloud, although our overall ACV is growing at about 20%, our Pega Cloud ACV is growing at over 50%. So as Pega Cloud becomes a bigger part of our business and continues to grow at a much higher rate, certainly, that will help lift the overall total ACV growth. We use ACV. And for those of you that have never heard ARR, think of them as interchangeable because they are really the same calculation. So now how will we execute higher ACV growth? Well, a key part of that naturally is not -- we're not worried about the market. We're not worried about our product fit for the market. The addressable market is so massive for us. And the product that we have is by third parties recognized as best or it's certainly in the top tier of any solution that's out there. What we really need to do is focus on our go-to-market organization, how we really optimize and scale that and also how we involve partners at an increased level than previously engaged. We always had system integrator partners. But we're looking at really changing the way that we interact with them in a way that they will be motivated to prospect and look for deals and really be advocates for us in the most strategic places where we fit because there's that vested interest for them to be able to drive the value that they drive with the implementation and the change management on the back end of a solution decision.

Helpful. And while we're on the subject of cloud, I'd love to maybe get an update on the company's cloud transition. Based on the investor update, it sounds like we're in the final stages of that. Can you just help us understand how the last stage of that will go and when we should be through that transition?

Sure. So I commonly refer to our cloud transition in 3 phases, and I'll just hit them real quickly. The first phase is changing the go-to-market, really changing what we sell. And that -- and we're done with that, right? We don't sell perpetual. It's a couple of percent in terms of the total amount of business that we do. So consider the perpetual as pretty much a dinosaur in terms of enterprise selling models. But we do sell -- we do -- we sell Pega Cloud and we sell client cloud. So everything is recurring, largely everything is recurring. So we're there. Second phase of that is the revenue transition. For any -- when you're going from a perpetual-based business to a SaaS-based business, you will have that reduction in revenue as you kind of get through that transition. And thankfully, although investors, I think, were very supportive, and I think we did a reasonably good job of communicating that, that was a confusing time in terms of the optics of what we reported for 2018, '19 and even '20. So we're finally at the point now in '21, where our revenue normalization is happening, where the growth rate of revenue really is more closely tied to the growth rate of ACV/ARR. So I think we're there, and we're at that stage. But the next phase, which is the last phase is the profit normalization because you really need to finish the transition and almost get back to where you started from in terms of stacking in the ACV that you're booking on SaaS from what you lost on perpetual-based business which takes about 5 years. Started this in the back of 2017, we'll be ending it at the end of 2022 in terms of that margin transition. So when we get to 2023, the business looks much different than it did when we'd started. It looks more normal in terms of cash flow, operating margin, revenue growth rate. We're really close. We probably have another 1.5 years to 2 years, and we'll be completely done with all the phases of the transition.

If it's anything like the last couple of years, it will be here before we know it. So you touched on the margin side of this. And I think gross margins are a really important focus for software investors. So maybe help us understand the gross margin impact of completing the transition? And then maybe where do you think those Pega Cloud gross margins could go over time?

So when we originally started the transition, we had targeted getting Pega gross margins to 70%. We recently updated in our Investor Day to say that we think that a target more like 72% to 75% is a near-term target, meaning just in the next couple of years, we're at about -- we're in the high 60s now. 67%, I think, I believe, was the last reported gross margin. So we made a ton of progress. We're almost to the 70%, 75% is, like you said, a couple of years will go by fast, and we're continuing to make progress as we get operating leverage. Because at 70%, we're still in under [ $500 million ] ACV SaaS business. So I think that our margins have been respectable in terms of their acceleration as scale. Now where could they go? Well, if we have -- if we leverage tools like Kubernetes, if we move some of our pieces of the application as part of fnx to multitenancy, if we continue to scale the size of Pega Cloud, all of those things combined, I think, gives us a shot to get into the 80s, like -- which is what I would consider to be best-in-class in terms of SaaS gross margin. Right now, we are subscale, and we are a single tenant. And I think that those factors do kind of create a mid-70s kind of target the way that we operate now. But I do think there's an opportunity to expand that in the future.

Great. Maybe one more financial question before we go back to maybe digging in some of the companies on the strategy side. A lot of times, investors use the Rule of 40 as maybe a framework of thinking about a company's -- where different software companies compare to each other. I'm curious maybe about Pegasystems' philosophical view on how they're managing that. And maybe what gives you the confidence that the company can get there along that framework themselves as well?

Sure. So given my background in private equity before coming to Pega, the Rule of 40 or the Rule of 50 or the rule of whatever, right, is really something that's kind of in my DNA. You really have to first step back and say, are you in a market that you can reach Rule of X, whatever that number is. If you look at the average for software companies, the average is more like a Rule of 32 or 33. 40 would be, I think, where you're kind of best-in-class is 40. There are some companies that operate at 50, 55, 60 at scale. And I think that those -- they typically have big competitive moats in terms of the -- to be able to drive growth and margin at that level. 40, I think, is achievable by almost every software company. And so if you're not at least striving to get to 40, I think your -- maybe you have your eye off the ball a little bit, is kind of would be my view. We have a business that really can grow as fast as we want it to grow, but it's the diminishing returns of efficiency on go-to-market that we have to be careful, right? Because you can always throw more capacity after 1 or 2 percentage point growth. The trick for us to be able to get to Rule of 40 is selling motion. It's the selling efficiency. It's not building new products. The gross margin will certainly help us. But the gross margin for our business is already scaling to the point where we're pretty comfortable we'll get where we need to. It's really about holding the machine and selling. And that's where partners can help us we're selling to -- and we sell vertically, of course. So having the vertical more mid-market accessibility. The product can help there for Pega Cloud. Partners can help to make that more efficient. And we really needed some of the sales experience that we brought in from other companies similar to us, they've seen that with a Rule of 40 or better kind of combined growth and margin profile. So that's kind of the trick for us.

Great. That's helpful. And then if I think about -- a little bit about the overall market, another company that's, let's call it, in Pegasystems' world, Celonis, just -- they just did a big capital raise at a really healthy valuation. And just maybe what's Pegasystems' view on process mining? I know it's something that's within your world. Is that something that you see as big of an opportunity as RPA for Pegasystems?

So process mining is something that Pega has done in some way or another for a while. Our Process Fabric is a sort of process mining to be able to go out to the applications and represent certain activities, certain stages, certain efficiency. The process mining that use cases around ERP adjacencies, typically around vendor management or collection management, I would say some of it is relevant for our use cases. Some of it is very specific to ERP gaps that exist, which is not as relevant for some of the markets that we're in. So I would say process mining is absolutely important. Pega has done aspects of process mining for a number of years. I think we don't sell a process mining solution per se. I do think a lot of the use cases that are -- that you're seeing out there, the initial value and process mining is -- some of it is a tangent to us. Some of it is not, I would say, necessarily the same as what we're doing for process orchestration, et cetera. So it is relevant. It will ultimately evolve to become more relevant. We're investing in it. We have components of it already.

Great. That's helpful. And then I've gotten a couple of questions from investors. So I'll weave those in. As a follow-up to the ACV growth acceleration, I had an investor ask, what would make you overshoot that acceleration goal of getting above 20%? Like what -- basically, the way I interpret it is what could go right or what could go more right than anticipated to help you overshoot the goals you've set?

So continued accelerated adoption of Pega Cloud is certainly a big lever because Pega Cloud is -- the adoption level and the growth has exceeded our expectations. If it continues to grow, even close to what we've seen it grow over the last few years, that will be certainly a lever that will help us. The second one is that really to have consistent delivery on our sales motion, right? We've been -- Pega has been great at penetrating large organizations and really expanding and growing with them. Where we need to get better is doing that consistently and predictably across a larger scale of organizations. So I think the 2 big levers for me are Pega Cloud and really doing that with more breadth across organizations that need and want what Pega has to help them with.

Great. And then I know we touched on RPA over -- don't worry, I know you almost had a little bit of hard tack. I know investors ask about RPO on earnings calls. This is not that environment. Just a Freudian slip from an analyst. I know we've talked about RPA through the conversation, but just maybe -- a lot of people view the market differently. I would love to hear maybe your view of where we are in terms of the market for RPA and maybe what the opportunity still is there for Pegasystems.

Sure. So I've recently kind of thought of an analogy of RPA to process automation. So there's a bigger view of process automation, which is how do we manage automating work end-to-end through an organization. Think of that being the analogy of an automobile, right? There's an end value proposition we want, which is to create a start to an end, and that is what I would call process automation. Robotic process automation is like the tires on the automobile. They are a tool. They can help. They should be used and many companies will use them and leverage them. But just because you make the tires doesn't mean you make the automobile. And I think that it's important to understand that although there is a place for robotic process automation, and there always will be because, there's disconnected systems, people using spreadsheets, data processing centers, there's going to be an opportunity there. There isn't a natural evolution that you start with RPA and somehow you end up with an enterprise application. And that's the example I use. You don't -- a tire manufacturer doesn't automatically compete with BMW or Honda or Toyota. And I think that there's a misunderstanding in the market of them being almost an evolution, right? Whereas we're going to start with screen scraping, and then one day, that screen streaming will become an application. We've had screen scraping since the '80s, right? Blue Prism has been around doing that and scraping off of pools like Pega and other applications for, I don't know, 20 years, right? So it's not something that's new. What's happening is like they've made the pools, including our tool, easier to use a little bit more OCR technology and some of the things that you can do to make it where you can get that 30%, 40%, 50% efficiency as an attended robot. And I think -- so I think there's value, and we solved that with our customers. I think there's a misunderstanding though, of automatically connecting that, that somehow you're going to use RPA to get rid of CRM applications or get rid of ERP or get rid of -- and I just -- we haven't seen anybody in the market, think of it that way. It's more viewed as a helpful mandate in places where the systems don't naturally connect. You have to deal with that. So there is an efficiency play there.

Great. Maybe just in the interest of time, we have time for one more question. And I'll end on you recently added the COO title as well. So it sounds like there's an expansion of your responsibilities. Can you maybe help us understand what drove that change and how we should think about kind of the operational structure with you taking -- dual adding of those responsibilities at both CFO and COO?

Sure. So about 1.5 years ago when we started to see Pega Cloud get to a larger scale, Alan and the Board had asked me to take over the cloud team. The Pega Cloud team, which included all of the operations, compliance, the AWS relationship and all the cloud engineering. And so I had taken responsibility for that in the back of 2019. The recent promotion, so to speak, I think is probably more of a representation of the -- what I'm responsible for, what I'm accountable for within Pega. You might say, well, why -- that's an interesting mix. You have all the CFO area, and then you have -- and I've kind of more of a broad expansion CFO. I have the CIO underneath me, I had a General Counsel, all of our business operations. But what cloud operations -- the reason why that makes sense is the cloud business model is the future of Pega. And so what Alan really wanted me to drive was making sure that, that model was optimized and that we were thinking about how that would look at scale because 5 years from now, 10 years from now, Pega Cloud is going to be the dominant part of our business. So I think that -- I think there was a very strategic business-focused leadership as opposed to operational groups that really was the reason why it made sense for me to take that on.

Great. Well, Ken, we're at the half hour mark. So we really appreciate your time today. It was a great conversation, and we wish you and Pegasystems the best of luck.

Thank you. See you next year in London.