Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

So we had disclosed that it was a -- it was about a $30 million impact to our revenue, and that's because it was accounted for as a term license. We call that client cloud. That's where our client buys a subscription arrangement and manages it on their own cloud environment, whether that be AWS or GCP or Azure or what are their own kind of -- roll your own kind of cloud. But they -- so that was the arrangement that the questions focused on. When you think about the ACV impact of that, there is maybe 2 incorrect ways of thinking about that, that the $30 million somehow translates to ACV. That $30 million was the revenue impact. And as most of our investors know, we sell contracts that are typically 3 years or so on average. So the next thing you might say is, well, that must mean it was $10 million a year, right? $30 million divided by 3 years. That would be a reasonable estimate, but that isn't an actual estimate of what I've talked publicly about that this was when we ramp our contracts, we typically start with a client where they start off with not the price point where they end. So this was impacting ACV as somewhere in the 5 million range or so. So although it was not insignificant, it wasn't the reason why our ACV or the sole reason why our ACV was so strong in Q2. Now what did we do with that client? That client is an existing client of ours, who spent a significant amount with us already. And we have increased the value of that relationship significantly through this transaction. And I think the thing that, that highlights is that the question that often gets asked of me, of Pega is you got -- you have great relationships with 200 to 500 clients. But you can -- are you sold out in those clients, right? Is there -- do you really have the ability to sell them anything else? Here's an example -- one example of clients where we have significant amounts of spend and we increased it. And guess what, we haven't even scratched the surface with this client in terms of what we could sell them. The solution itself is really focused on one-to-one customer engagement, right, which is our decisioning comment that I made earlier. It's really around helping make decisions when clients come to a website around upsell, cross-sell, retention, engagement, education. So that's really kind of the area that the solution was. But it's just a perfect example that we're not even remotely sold out in any of our organizations. And here's a perfect example of one that materialized in a client that was already spending millions of dollars with us a year.

That's great. The next question kind of comes in on circling off of the competitive landscape to sort of go-to-market motion. Hayden Stafford, the Head of Global Sales of Pega, has now been with the firm for over a year. Any impacts on sort of how the firm is going to market?

So we made a couple of fairly big changes to our go-to-market. The first one was partners and the way we engage with partners. And I would say that is not exclusively because of Hayden, but I would say Hayden is the biggest instigator, biggest supporter of partner engagement. We had relationships with our partners over the years, but more in an execution way. They did the implementations, they were the global system integrator, they had Pega-certified resources, we worked well with them, but not in a selling capacity. We never went to an Accenture, for example, as just one example of a partner and actually said, hey, we want to be -- we want to work together on actually opportunities where Pega and Accenture can actually help our clients. Same thing with Cognizant, with Capgemini, with Ernst & Young, go through the list of those. Those SIs have tremendous relationships with our clients. In many cases, they are better relationships than we would ever have because they're living with those clients and helping them on their digital transformation. So that was a big change for us. And I think we're in the early innings of it, but the response we've had from our partners is amazing. I think they were waiting and hoping that we would do this at some point. So I think that's one big change in the go to market. The other change that's happened over the last couple of years is that we're really focused more on solutions than just a, we have a blank platform, and you can go customize on top of it. That was our business 25 years ago, right? We went in and said, we have this powerful platform. By the way, a lot of software companies 25 years ago had the same model. They have a platform, it's kind of raw material, they'll build something that is unique to your situation. We focused less on that in the last few years and more on you have common problems based on your business model, the vertical that you're in, the regulatory environment, the clients' expectations. And we are going to use our platform, our powerful capability based on those use cases. And so the configurations that you actually want to sell to a client are more complete. You're coming in with a customer service solution for, say, a virtual kind of contact center, a desktop replacement for call centers. That's not -- you're not just saying, here's a platform, go build one. You're saying, here is the template. And it might be 70% or 80% done, and you're just configuring that last mile, so to speak, of what the client might want. So those are 2 very big shifts that we have that honestly, that open up the addressable market, not just with new logos, but also within the clients that we've already penetrated.

Very good. Pega is opening a new office in Waltham, Mass. What's the strategic rationale for that move? And any other thoughts on just other locations or geographies that you're looking at?

So we, as probably everybody out there have been trying to navigate this whole pandemic thing and what does it look like, and what do our employees want, what do our clients expect. What we -- we actually had maybe even you might say, the benefit of having our landlord and our primary building actually kind of forced our hand to exit our building, so to speak, because they were building a lab building, right, which was -- which as many of you might know, in Cambridge, Massachusetts, pharmaceutical, biotech, is really -- that's a hub for it. And given that we had to move, we made a decision, and we pulled our employees. And what we found was that our staff members wanted to be able to come back in the office but they didn't want to come in with the regularity that they did before, probably not that different than most people that you would have up here that would tell you that. We are not prepared to go to a full remote kind of environment for our workforce. We also know that people are going to want more flexibility. So what we decided to do was get a smaller footprint office in Cambridge, which we will still use as our corporate headquarters. We will have a visit center for clients where we could showcase some of the solutions and the use cases that we've helped our clients with. But -- and we actually have a small office North of Boston, in New Hampshire for people that live North of the city. And so we really tried to create an option where we would cover as many of our staff members as possible where they lived and really kind of reduce the commute and give them options to go into 3 different offices. Waltham will be our biggest and are most frequented by our staff, and it's centrally located in the kind of right in the western suburbs of Boston, where a lot of our employees are within a 10- to 25-minute kind of commute. So we felt like that was a good balance of still covering people that lived in the city, people that live North have an option if they wanted to work in New Hampshire, we have Waltham. And we're going to probably be similar to what a lot of companies are doing, which is more open seating, more collaborative space. We're really kind of trying to engage the workforce. That's what we're really excited. Now we won't be in there until the beginning of 2022 because of the time that it takes to build that out. So we'll still be working in the New England area in somewhat of a hybrid kind of commuting -- excuse me, hybrid virtual work environment. Globally, we have about 30 locations that are offices where we have some population of staff. We will likely have a similar kind of office frequency as we see in North America, where staff members will -- we'll encourage them to go in the office. We're not going to force them. We expect them to want to go in to collaborate with their team members. And I think once we get to 2022 and this pandemic is behind us in most countries that we operate in, I think we'll see kind of a probably a 3-day a week kind of frequency for most of our staff. So that's kind of our -- that's our prediction. But things can change, of course, but that's kind of where we are now.

Understandable. And I'm sure there's a lot of demand for your employees in general. And can you talk any thoughts further on just retention and how to keep employees excited about what do you have going on versus a lot of other options in the industry?

So it's a great question because in today's world, you can't just pay people to stay, right? Like there are options. So it's not a matter of -- I'll just -- we'll just pay everyone more money than another company. That's still -- you still won't retain people with that. You have to pay adequate certainly, you have to pay market but you need to have a package, right? You need to show them that you're paying them fairly, that you're creating a work environment that is consistent with what they expect. You're giving them development opportunities, which is why growth is so important. If we're a growth company, we create opportunities as the business gets larger. They also want to know, I would say, increasingly the newer generations to the workforce, want to feel like there's a purpose to what the company is doing, right? And so for us, it's great because we're connecting to our clients and helping them scale their businesses and helping them serve their clients. So we feel very connected to that value proposition of how we're helping our clients. And we did extensive surveys with our staff members about what was important to them. And overwhelmingly, our staff members, certainly through the pandemic, expect for opportunity for advancement, for purpose of the company and for a level of flexibility and accommodation because everybody's situation is a little different with their comfort level of returning to the office. Some people are returning now. They want to be in the office now. And other people are either because of health issues or other concerns are not ready to do that yet. And I think that if you're trying to really be an employer of choice where people want to work for you, you've got to really be as accommodating and helpful to your staff members. Telling them what they need to do, mandating things that they need to do, forcing them to -- I mean it might work in the short term, but you're not going to retain staff in that kind of environment. And so we're really trying to be respectful of our -- all of our stakeholders, our shareholders, but also our employees and our clients as well. So it's a needle to thread, right? Because you also want to create the right responsible environment. But I think our employees really expect and need for us to help them be successful in their careers. And flexibility is an important part of that.

Great. And so just for somebody newer, you guys have talked about the Rule of 40. Can you help us understand like what is the Rule of 40? And why is it important to your business?

Sure. So there is there's a simple model that I think of, which is really a kind of a concept of maybe scarcity, diminishing returns, different things that we've all kind of heard in our -- through our careers. Rule of 40 is when you add together the growth rate of the business, which we define as the growth in our ACV or Annual Contract Value and you add that to the profitability of the business. So you could use free cash flow margin, EBITDA, whatever is relevant for your business. If you add those 2 and you're not at 40, right, so if you're growing at 20% and your margin is 20%, that would be 40%. If you're growing at 10% and your margin is 30%, that would equal 40%. If you're not at 40%, you should ask yourself why you're not, right? And you should really think about is this a business model problem? Is this -- are you just less efficient or you should -- maybe you should be 50, Rule of 50, right? But there are different models wherein technology, most technology companies should be able to get to the Rule of 40. But the reality is the average across all of tech is 32%, which means that most people are not running the business in the way that they should. That's the reason why there's a lot of companies that get taken private because they get fixed, right, because they're not actually being efficiently run. We believe that we should be accountable for that as a company. We are -- our staff, our company, we should be accountable to ourselves. This isn't accountability to shareholders as much as it is accountability to what is the right way to run a business, which then shareholders will benefit from. So we use that Rule of 40 as kind of a mantra of where we aspire to be when we get through the cloud transition and our numbers are kind of normalized. And 40% is not an end point, right? It's kind of an exit on a highway to getting more efficient. And I think that we have, I would say, established a good base of recurring business that allows us to improve our profitability over time. Now one last point on the Rule of 40. There's an implied equality to 1 percentage point of growth is the same as 1 percentage point of profitability. And I think we know in today's environment that growth is more valuable. So certainly, when you think about that mix of 40, we are skewing more towards the growth being the faster, the bigger component of that Rule of 40.

Thanks for that, Ken. So Pega Cloud margins have been expanding over time. Can you talk about how Pega has been achieving the margin expansion and what you've done to boost that out?

Sure. So our margins when we first started Pega Cloud -- I shouldn't say when we first started, maybe I'll use -- when I started at Pega 5 years ago, the Pega Cloud business was about $25 million in revenue with a gross margin of about 30%. So that was where we started from. If you go now, we've got a Pega Cloud business that's well over $200 million with gross margins approaching 70%. Some of that is just the operating leverage that you get as you scale a business. Some of that is our efficiency and how we run on our infrastructure providers, how we actually automate things. Some of it is just the way that we've used tools like Kubernetes and otherwise to be able to simulate efficiencies of things like multi-tenancy in what is right now a single tenant, single client environment SaaS solution. So I would say the operating leverage piece of what we've done will continue as we become $500 million, $1 billion SaaS business, you'll continue to get incremental operating leverage. I would say we made a really big change in the past 18 months that really helped our margin around managing infrastructure costs, scalability and the efficiency of our base platform. And that's really helped us get a big jump start to getting ourselves above 70%, approaching 75% over the next few years.

One question came in on just any updates or the latest with Project Phoenix, if you want to make any comments there.

Sure. Project Phoenix, we talked about, I guess, it was probably 2 years ago maybe at PegaWorld. It was really the way we thought about the future of Pega, the product, which is a product that is built on micro services that has every bit the power that Pega has always had but in an environment where you can run it nimbly, you can push capability upgrades, you can isolate certain activities that where if you needed to affix something, which does happen in technology. It also allows you for to have partners like independent software vendors, ISVs, that can use your platform to deliver services and offerings that they would do to certain markets. One of the beauties of that is that you can get into different verticals in different regions, and you don't need to build the sales team to do it. You can literally kind of white label, so to speak, your platform to somebody that will build a solution on top of that and offer that. And they'll be able to manage that cloud environment and they'll leverage Pega to do it. So that is really where -- that's kind of at a high level where -- what Phoenix is. In terms of where we are in the journey, we're well over halfway through that journey. We think we'll start to see parts of Phoenix really be the way we operate when we're in the 2022 year, certainly '23. It's not an impact for '21. It's also not a distraction in terms of our go-to-market for '21. But you'll start to see in '22 that components of Phoenix will become real. And the ISV discussion that I mentioned will become something that's more real as well.

Ken, we have about just over a minute left. I just wanted to say thank you for this. And are there any final thoughts that you want to leave us with in that last minute? We appreciate your time today. So thanks again.

I think it's always great to be able to help clarify some questions for new and also existing investors. And I would just continue to focus everyone on ACV is the most important measure. We will continue to sell what we call Cloud Choice, which is allowing clients to support their solutions on their own private clouds. We prefer Pega Cloud. So we certainly try to encourage our clients at an increasing pace to leverage Pega Cloud, but our business is all about that subscription line. We want that line to grow at an increasing pace. And I think we've got the team and the product and certainly the market to make that happen.

Very good. Well, Ken, we really appreciate you and Peter participating on our conference today. And thank you for all the thoughts, and hope you have a great rest of your day, and look forward to working with you again soon. And thank you all in the audience for joining us. We appreciate it.

Thanks, everyone.