Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

All right. Good morning, everyone. Thanks so much for joining us and for kicking off the RBC TMT Conference. Really excited to -- for the next few days and, again, thank you, everyone, for joining us. I'm delighted to have with me, from Pegasystems, CFO and COO, Ken Stillwell. Ken, thank you so much for joining us. It's always a pleasure to have you.

Thanks, Rishi. Good to see you.

All right, Ken, let's maybe start high level for the generalists in the virtual room with us. Just start with an overview of Pega and kind of the evolution that you've seen in Pega, especially since you've come and joined as CFO and, again, taking over the COO reins pretty recently as well.

Sure. So Pega started off in, I would say, more custom software development market. We did build some -- and I'm talking back to the '80s. We did build some tools that helped us kind of repurpose and resolution components of what we did so that everything wasn't so custom. But as time went by, we ended up with a workflow engine and a case management engine. Those were kind of our 2 so like a process engine and the container of how you actually executed the work. And we -- and that was -- those 2 pieces were the early foundation of what was called BPM. And that -- the BPM has a series of use cases over the years, typically around connecting steps in a multisystem process. So things that might interact with other systems and that you need to kind of manage kind of in an end-to-end, things that typically didn't have 1 step, they would typically have multiple steps as you executed it. That led us into through an acquisition that we did as well into the front -- or the front office or CRM back in the 2010, 2011 time frame. Now we really didn't start to really think of ourselves as a CRM company, probably about '14 or '15. So maybe 6, 7 years ago, we really started to see front office use cases, CRM, operational or back-office use cases, BPM. And those are, today, still the 2 primary kind of value propositions we have to help with operational excellence and efficiency and connectivity and real-time speed across end-to-end work automation and also connecting customer journeys across different customer engagement systems. In addition to that, our system is we sell what you might call applications, where a specific use case is configured on our platform, like, say, marketing automation or customer service automation, where the clients will buy, will replace what was maybe a legacy system or maybe they just didn't even have a system, and they are actually developing new capabilities. So fast forward to the last few years, we realized that the market was really moving towards this, what I would call, cloud native kind of environment, where we needed to have a cloud offering, that's Pega Cloud. But in addition, clients wanted to manage the offering sometimes on their own virtual private cloud. They might be managing on AWS or Azure or GCP or whatever the cloud of choice is. And so we decided not to force all of our clients to only deploy on Pega Cloud, but we certainly encouraged them and showed the value of Pega Cloud. And what we've seen is about 50% of our clients on Pega Cloud, of new growth of Pega Cloud, and about 50% on Client Cloud. To be completely honest with you, I probably thought that would have been even more on Pega Cloud because of the big push on SaaS. But what we realized is that there are a lot of use cases where clients really need or want to manage that environment inside of their kind of virtual private cloud. So that's kind of the journey from more custom solutions in the BPM, expanding into CRM, our movement into the cloud and kind of where we sit today.

Great. That's a really helpful overview. I want to drill down into a comment you made, Ken, which is about the Pega Cloud versus client cloud mix. 3Q, we obviously saw what was a strong quarter for client cloud. Maybe help us understand what drives that decision for customers to choose client cloud over Pega Cloud. And you talked about maybe specific use cases, but maybe drilling a little bit deeper into that. As you think front office versus back office, is there one that tends to lend itself more towards Pega Cloud versus client cloud?

Yes, great question. So I'm going to make a little bit of a generalization just because -- just to kind of give you an idea of where the mix tips in one direction or the other. So a solution like one-to-one customer engagement, which is in a digital channel, like a website, in real time, dealing with people coming to say -- consumers coming to say, a credit card website, where they might be paying $20, $30, $40 for the -- for a click to be able to get a person to come in to originate a credit card. When they get that client there, they want to convert them, right? So that's kind of something that would typically lean more towards Pega Cloud because that's a contained solution in a digital channel, and the client really doesn't want to manage that. Now it might still connect with certain information and decision models that may actually reside in a client environment, but that's an example of something that probably would be 80%, 90% likely to be Pega Cloud. When you think about orchestration, workflow that sits inside like connecting 15 different systems in a client environment that may all be, say, in their virtual private Azure cloud, just using that as an example, that would be something that would probably be more in the 80% to 90% likely to be on client cloud because they want to keep the -- they don't want to have calls going outside of their firewall to a public cloud and literally instant, within milliseconds. Just the speed of the traffic would slow down the real-time transactions. So that would be an example where clients might -- so think of more infrastructure of operations, of connecting multiple systems, more client cloud, application software that might solve a 1- or 2-step solution like a virtual customer service, call center application or one-to-one customer engagement or sales automation. Those would typically be more Pega Cloud. So that's kind of -- I'm generalizing, but that's kind of the way we've seen it.

Yes, okay, that's really helpful. And so a 2-part question to kind of think about this because I get this from investors a lot. Number one, I know you're not forcing anyone to go one way or the other. Cloud choice is obviously a very important part of the value proposition. Are you giving any incentives, though, soft incentives, to either the customers or salespeople to choose or to even migrate to Pega Cloud? And maybe longer term, how should we be thinking about what's the target mix or steady state mix of how much business is Pega Cloud versus client cloud?

So I'm going to leave out Project fnx and the evolution to make ISVs, et cetera, more relevant because that would skew much more towards Pega Cloud than client cloud. But if you just look at the base of our business right now, we're -- if you look at the last, I guess, it's probably been 3.5 years or so, we've had about a 50/50 mix of the 2, pretty close. One quarter, it might go up to 70%, one direction; the other way, it might be down to 40%. Pega Cloud has typically stayed a little more than 50%, but pretty close, like in the 50-ish, 55% range. To be honest with you, I would have expected it to probably go a little higher, more towards like 60% to 65% Pega Cloud. And that might actually happen over time. But we are actually incentivizing the clients through a value proposition that is different. The value proposition of Pega Cloud is, we've got you covered. We do everything. You don't even -- you literally just have to interact with the application. We'll do everything as fully managed. In some clients, that's tremendously valuable, and that's what they want. If we went to a larger organization like a large bank or a large health care provider, they might look at the use case and say, although we see value in that, we really need to control this data in a way that we can't do it in a public cloud. And we may have multi-country, we may have regulatory. So that's kind of where -- although we incent clients, and we incent our sales team because sales teams naturally they get paid on the dollar of ARR, and a Pega Cloud has a slightly higher ARR, so they would get a slightly higher commission. So we are incenting both our clients and our sales team to sell Pega Cloud. However, the value of the use case in client cloud is powerful. And so therefore, there are some use cases that, even though a salesperson may make more, even though a client may see the value, they may say, we really need to manage this inside of our virtual private cloud.

Yes. Got it, got it. All right. On thinking about Pega Cloud, this is something I think is still not fully understood by investors, and hence, why I think I ask you this question every single year that we do these. Architecturally, right, Pega Cloud is single tenant, right? Most SaaS we always think about as multi-tenant. I think the very critical exception is obviously ServiceNow, which is single tenant, they call themselves multi-instance. Maybe can you help us understand the -- why the choice for single tenant, kind of the trade-offs of single-tenant versus multi-tenant? And then where are the areas you've talked about being able to leverage multi-tenant services around the single tenant core to help gross margins and, eventually, might even be able to help you get a little bit more down market as well?

So it's a great question. And the way I would say it is, similar to ServiceNow, as you mentioned, a single-tenant architecture, where you have the ability to still upgrade classes of customers like its multi-tenancy, that really is the desired outcome for clients because they can always stay current, and that's what Pega is doing with Pega Cloud. So they can always stay current, but yet their data is isolated. Their data is not put into a table with all of their competitors, where it's rows and columns and sheets of data. And the reality is, multi-tenancy, in certain aspects of the solution, is really a margin driver for the vendor. It's not a value proposition for the client. And so what we feel like is the best of both worlds is to have as much multi-tenancy as you possibly can to, a, get efficiency, of course, because some of that efficiency, you can share that with the client. Second, allow yourself to have continue an instantaneous and current updates and upgrades, right, so that the product is always current, but not go so far as to throw all the data just in one place, unless the client is comfortable with that. In the SMB market, that's typically where -- when you go more up to enterprise, you see more single tenant, when you go down to SMB, you see almost exclusively multi-tenant because you have to build the efficiency. And you and I, if we have a Gmail account, we don't have the power with Google to say, please make all of my e-mails be at a single-tenant environment because they're selling to tens of millions of clients. So that's kind of the way single tenant, multi-tenant typically works, but you cannot have a monolithic single-tenant service model, right? And that's where we've changed. We basically moved to where our services are multi-tenancy, our control planes are multi-tenancy, things around that. But the data isolation is where the single tenancy really resides and will continue to reside. So that's kind of our model, and it is very similar to a ServiceNow. It's not like a Salesforce, just to kind of compare and contrast.

Yes. Great. And so as we talk about efficiencies, that leads us into -- I'm sure your favorite question you always get, which is about gross margins. We have been seeing, obviously, cloud gross margins moving in the right direction. Just how do we think about the long-term gross margin potential, both in terms of overall gross margins as well as, specifically, what's the scalability and long-term cloud gross margin profile?

Sure. So I'll specifically talk about Pega Cloud, but then I will put it all together in terms of our total subscription revenue and how to think about it. So we broke out the 2, not because we see that there are different solutions or different value propositions. To the contrary, the solutions are exactly the same, as you know. We broke them out so that we could identify and track the gross margin improvement around Pega Cloud because that's an important lever. As the business becomes a 50/50 at the ACV line between the 2, you've got -- you need Pega Cloud to get that gross margin up into the mid- to high 70s because the client cloud gross margin is going to be in the low 90s. And when you blend the 2 of those together, you're going to end up with a gross margin that looks like in the mid to -- low to mid-80s, which kind of almost looks benchmark to what you would think for a subscription or a SaaS business. So if you put it together, our gross margin, sans professional services, is approaching 80% right now. We believe that will get up probably closer to the mid-80s. And how that will get there will be on the gross margin for Pega Cloud getting to 75% or higher.

Yes, yes. Got it, got it. All right. I want to maybe pivot to and think about some of the changes within the organization, and specifically drill on Hayden Stafford. So he's now been at Pega for, what, coming up on 2 years, if I'm not mistaken. Maybe a little less than that.

1.5 years.

1.5 years. yes.

June will be 2 years, yes.

Okay. Okay, yes. So with Hayden Stafford joining, and at the same time he became COO, he got promoted to President. Can you talk a little bit about what changes you think you can make to drive higher sales efficiency and ultimately accelerate ACV growth? I know we had him at the investor session earlier this year, and it was great to have that level of exposure to them. Generally, how have some of the changes that he's been brought been received so far? And how do you think about how long it takes to see results from some of these changes?

Yes, so I would start -- maybe I'll start with the end of your question and say, I think we've already started to see some momentum in Q2 and Q3 with the incremental ACV add that we had in Q2 and Q3. We went from our ACV growing in the low 17% range constant currency, up to almost 21% constant currency in just 2 quarters. So I think we've actually seen that. Now how did that happen? What are some of the -- how -- what does Hayden specifically bring to the table that we need, that we want, that we value? Well, it starts with his experience. He has been at the companies and the scale in the space we're in and the exact space we're in and companies growing at very healthy rates in and around what we sell. So competitors to Pega. Second thing, he's a very disciplined and organized sales leader. He understands the importance of sales cadence. He understands the importance of building pipeline, of really driving the right kind of behavior in the sales team. Third, he appreciates partners, right? The importance of system integrators and how they fit into the selling process with -- in the enterprise level. So SIs are very important in enterprise selling. They're not as important in SMB selling, right? But they have relationships in these large companies, and they see opportunities. They can refer opportunities to us. They can give us credibility. They can be aligned with the road map and the value and the architectural discussions that happen with our clients. And I would say maybe a last point that I -- that is, for me, is he really is focused on building an efficient sales model, making sure that more and more of the salespeople that we have in the company are hitting their numbers or coming close to their numbers. And that's not -- in enterprise selling, 50% or slightly there above is actually the percentage of AEs that actually make a quota, right? It's not like an SMB, where you might have 80% or 90%. In enterprise, because there's an overperformance, the averages kind of gets to the same place in terms of productivity, but you do have more volatility in the performance of enterprise AEs. And Hayden's very focused on trying to address that and to try to help that be optimized. And that's always been a challenge for Pega, where we've had Wales, we've done well, but not all of our sales team is highly productive. And they probably -- that probably is an unfair target to even have as for everybody, but to have a much higher percentage of our sales people kind of in the money and hitting their targets and beating their targets on a regular basis. So I just think that Hayden is really the right type of leader for the stage that we're in at Pega, which is getting to that kind of next plateau.

Yes. Great, great. I want to think a little bit about the sales people you've had and specifically think about the hiring environment for salespeople. And maybe this is kind of a 2-parter. Number one, I know when we were having this conversation about 1.5 years ago, you made comments about wanting to kind of keep your foot on the accelerator in spite of the uncertainty out there. And it sounds like in contrast to a lot of software companies, right, no hiring freeze and definitely no risk or anything like that. Maybe talk about what drove that strategy and what you've seen as a result? And then tying that into we hear constantly about the labor shortage, and software is not immune to that, right? It is getting tougher to hire qualified sales reps. What are you seeing in terms of the hiring environment?

So 2 parts to that question. One, you're absolutely right. We felt like there was no way that we could slow hiring or do a hiring freeze or anything because we just felt like the opportunity with digital transformation and what kind of the pandemic did to digital transformation. The importance of it was just a great opportunity for companies like Pega. So you're right, we absolutely did hire kind of right through the pandemic. The hiring environment is challenging. I would say -- maybe I'll say it, there's hiring and there is retention. Because retention is challenging, there's lots of candidates out there. So maybe I would say hiring isn't as challenging. It's more of a revolving door of salespeople moving around through technology as the bigger risk for companies like Pega and other companies that we compete with. So you really do need to make sure that you have a great solution that the sales teams that are in the company understand how they can make money, that they can actually be productive and be successful because, naturally, that's what's going to make people stay with you. That's going to help your retention. But I would say that, for sure, as the pandemic wanes and as people start to rethink about their life and where they want to work and how they want to work and return to office and all the vaccine requirements and all the different noise that we've put into the system, it's a time for people to step back and go, do I want to be with this employer, right? Do I want to -- do I want to be in this industry? Do I want to be in this city? Heck, do I want to be in this country? So I think that there's a lot of decisions that people are making. That is really the challenge that all of us in the industry are dealing with. The hiring -- those individuals aren't going to just retire and stop working. Those individuals are going to come back and recirculate into the ecosystem. So I would say -- and more people are coming to tech than leaving, right? So you're going to always have the -- so I think the bigger challenge, Rishi, is not necessarily even the hiring. It's just the turnover risk that you keep reading about and hearing about. And we just have to be -- we have to be an employer of choice, where people want to be with Pega. And that's always what we've tried to do. So that's kind of how we're going to battle that.

Yes. Yes, great. All right. Then I want to talk about the partner ecosystem. You discussed about making the product obviously more GSI friendly. But I think, in the past, you've also talked about taking the strong partner ecosystem and the thousands or more Pega-certified people at the large SIs and maybe leveraging them as a direct channel partner, similar to what other software companies do, and actually generating sales to partners. Can you talk a little bit about that opportunity and what sort of momentum you've seen from that?

Sure. So there's kind of 2 pieces to that as I see it. One piece is to go to a company like, say, an Accenture and really have them be motivated to drive Pega license-attached sales, as I would call it, meaning they're not going to go out and they're going to -- they're not going to go out and just sell a solution on their own. That's not the nature of their business, nor is that the nature of the transactions that might happen to the enterprise space. But they're going to know the solution. They're going to know the value proposition. They're going to work with the client and how to roll that out. They're going to help them with vendor selection. They're going to be able to understand the differences between, say, us and our competitors. And they naturally have a serious pool of skilled resources. So they're going to be really driven to help the clients achieve those values in a partnership arrangement. That's something we're doing much tighter with our GSIs, as you said, because we really were -- we were thinking about that almost over the time as a sequential step. We sell the implementation partner deploys. We're trying to really kind of be joined at the hip there. The second opportunity, which we have not started yet, which I think is -- which is something that will come with fnx in the 2023 kind of time frame, is this ability to go to kind of distributing partners that might sell a managed service. So now what you're going to sell is almost the white labeling of the Pega solution that an implementation partner might then take, configure and sell a managed service. The example that I always like to use as an example that I saw in another company that I was at, where a company like Boston Scientific build a platform to do a device identification and management. So when you actually bought their equipment, they would help you keep serialization, the maintenance of the equipment, et cetera, and they sold that as almost a full service to be able to monitor in a hospital or in a doctor's office. Think about that as a solution. That's got to run on something. What would that run on, that could run on, that example could run on a solution like Pega, which is managing the workflow. So that's kind of how I'd thought about it.

That's helpful. You've mentioned Project fnx a couple of times. And I know Alan has talked a lot about it through the years. Why is -- I guess what is Project fnx? And why is it so important for Pega?

So Project fnx is really, I would say, the final leg of taking the Pega solution and allowing it to be deployed kind of at scale at use -- at lower use volumes, more clients to be able to, right? If you think about what Pega has been before the first evolution, which is to move a lot of our services to multi-tenancy, to be cloud native, et cetera, the solution was much more of a solution that got deployed on a server, right, got deployed in a data center, right? It was -- that's the solution of the '80s and '90s, right, and even the 2000s. The solution of the 2010 in the last 10, 15 years has actually been a solution that's really continuing to work on multi-tenant services, continuing to move towards cloud native. What fnx is kind of that last piece of it, which is allowing clients to be able to run Pega in a multi-tenant environment at the data level. Meaning you might sell the white label solution to a -- using the example of selling it to a Boston Scientific to just picking a company name and allowing them to actually sell it to doctors' offices in a multi-tenant environment that would run with really the same configuration across all of those different customers. And that's really a different solution than what you have now, which is each customer has their own configuration. In the multi-tenants, you could have a scenario where all the clients had the same configuration, and you're actually almost renting that service to clients. That's kind of that last step in the evolution, which we call Project fnx.

Yes. That's helpful. All right. Now let's maybe pivot to talking about the competitive environment, right? Maybe help us understand how do you think about it. And maybe let's break that up into 2 parts, right, the back office side with Appian and then now UiPath coming public; and then the front office side with Salesforce and maybe with Microsoft, especially because they seem to be making a bigger push with dynamics recently. And we did mention ServiceNow earlier. Do you see potential to go against them over time?

So the way I think about the competitive landscape is, when someone wants to buy a CRM-type solution, we typically are competing with the companies like Adobe, Salesforce, Microsoft. There are others, but those are 3 of the larger ones. I would say Adobe being pretty -- on a much smaller scale because that's really around the marketing automation. In fact, we even partner with Adobe, in some cases. Oh, and by the way, we partner with all 3 of them in actually many ways because we integrate and interoperate with all 3 of them in the front office. When you get to the operational side, that's when you might see like an Appian, right, in a specific vertical. You'll also see Salesforce there. And by the way, you'll also see Microsoft there. So some of the same competitors in the operational area as well, you might see a ServiceNow there. Typically, ServiceNow tends to -- we tend to see them really concentrated in the internal IT buyers and our clients. And that's not -- that isn't our primary buyer in terms of what -- who buys Pega. It's typically more like the Chief Technology Officer than it is the Chief Information Officer, once again, generalizing a little bit. When you see things like -- when you see companies like UiPath or even the low-code providers, like someone that's not more like simple low-code kind of solutions. Those are more point solutions. And we don't really compete with like an OutSystems or a Mendix in the same way that we would compete with an Appian or a Salesforce. Because Appian has more of a kind of a workflow platform versus what Mendix and OutSystems might have as a very specific low-code, simple application development environment. So we don't typically compete with them on an enterprise solution. We compete with them on a point solution. So we have a product that competes with UiPath or desktop automation. Clients will buy that to augment not being able to connect, say, the systems that maybe don't have an API. They'll use screen scraping or RPA to do that. But those solutions don't compete in the end-to-end workflow. So that's kind of the way I think about the market. There's kind of ones that are very like-for-like with us, which is Salesforce, ServiceNow, Microsoft and even, to some extent, Appian, in a little bit in -- certainly in the back office way. And then there's the point solution providers, like UiPath, Blue Prism, Mendix, OutSystems, which we really don't see a strong competition in the enterprise space from them.

Yes. Got it, got it. All right. In the minute or 2 that we have left, I want to talk about the long-term profile, right? You've talked about becoming a Rule of 40 company. What is it that's giving you confidence in reaching that target? And I think, more importantly, how sustainable do you think that kind of steady-state 2023 financial profile will be?

So assuming that we're not putting a lot more fuel on the growth fire, let's just -- we are a business that has extremely high retention, lots of radiation or up and cross-sell from our clients with, I think, moving to very healthy gross margins, where our professional services becomes a smaller and smaller part of our business, in a large growing market, where we're a $1 billion of ACV in a market that is $100 billion or more. I think all of that would suggest that the economies of that are easy to get to Rule of 40. The wild card is how much fuel do you want to put to drive future growth? That becomes the lever. We don't have to spend 30% of revenue on R&D. We don't have to spend 15% of revenue on G&A. We have reasonable gross margins. So we have no fundamental issues with getting to reasonably high free cash flow margins and even modest growth. The question is, if you want to be higher growth, how much sales and marketing? So I think the trick for us is really just that sales and marketing leverage. It's really nothing else. And then the question is, how sustainable is that? Assuming we're not inefficient in distribution, Rishi, then it's very sustainable. So the trick for us is continue to grow, continue to drive efficiency and optimization in the go-to-market, and we'll have no problem being a Rule of 40 or, quite frankly, much higher than that.

All right. Great. Great, Ken. That's just a great place to jump off. Thanks so much for being here. Again, always a pleasure to have you. And thank you, everyone, for joining us.

Thanks, Rishi. Thanks, everyone. Bye. Have a good day.