Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Good afternoon, everyone. Thanks for joining us at the 25th Annual Credit Suisse Technology Conference. My name is Rich Hilliker, and I'm a Software Analyst here at the bank. We're excited to have Pegasystems with us today. Ken Stillwell, COO and CFO. Thanks for joining us.

Thanks. Great to be here.

Excited to be back on stage together again. I think this is the first investor conference that you guys have done since the start of the pandemic. How does it feel to be back in person meeting with everyone again?

It's kind of a little surreal. I mean we've done a few -- admittedly, we've done a few NDRs locally kind of in Boston and New York. And I would say the turnout has been -- it's not -- people aren't quite there. But it's great to be live and great turnout and seeing everybody so many people I feel like I haven't seen for like ever -- it has been 2 years. So it's great to get back at it.

And great to have you here. So maybe why don't we dive in and just kind of level set the playing field. I know Pega's been around for a long time, and it's well known and loved by a bunch of investors. But for those who are new to the story, could you maybe give us a sense of the company strategy and some of the key solutions that you guys have today?

Sure. So Pega is an application. Think of Pega as a software development platform, an application development platform where much of what we do on the platform are use cases that execute work through a series of steps, commonly called workflow process. So it's really -- the simplest way to think about it is it's an environment. It's an application platform. We -- people use us to execute repeatable tasks, processes at scale. So things like managing disputes on a credit card website or managing loan originations or credit card offers in a digital channel. There's -- you can pretty much any large company that deals in a B2C world can think about transactions that happen at scale that need to happen fast, real-time. And as automated as you can, trying to take the human interaction out as much as you can.

Got it. That makes a lot of sense. So maybe let's talk at a high level here. Since 2017, Pegasystems has been going through a business transition. You guys have been shifting from towards subscription. I'm wondering, can you give us an update? How is that transition going? Where are we? What inning are we in to use the baseball analogy? And how are you feeling about the where we're at?

Sure. So there's -- I think about this transition as a series of steps. I've commonly referred to 3 parts of this. I'm sure there are different ways to think about a transition. The first one is to change your go-to-market motion. How does your sales team sell? How do they think about selling? Are they incented to sell on a recurring model? I would consider that to be done. It's been done for a couple of years. We sell 95-plus percent of our -- all of our new business under a subscription model, which means that the business has really become a subscription or recurring business. Back from in 2014, 2015, 2016, where we were selling 2/3 of our new business under a perpetual model. So it's a fairly big shift. The second piece of it is really the shift that happens in terms of the stacking of the new ARR, we refer to it as ACV, ARR, ACV, same thing, into the business. That first year, you wash away all the perpetual licenses and then you start stacking in the recurring. And it takes typically between 4 and 6 years depending on how fast your transition happens, so you're able to stack back kind of all those years that you've kind of almost starting back at 0. We're probably about 80% of the way through that. We anticipate we'll be done at the end of 2022. It's about a 5-year process. So at the end of this year, we'll be about 80% done with that. So 4 out of 5 years. And things are starting to look much more normal in terms of our -- the size of our subscription base and even the subscription revenue growth compared to the ACV growth has really converged tightly. The last piece of it is where you not only get through the transition, but you get to the other side of the transition in a perfect world or in maybe a textbook manner. When you get through the transition if you do nothing else, your business should look largely the same as when you started the transition except now your business is recurring, and that's where your margin accretion and your operating leverage can really kick in. So the last phase of it is where you start to see your cash flow normalized, your operating margin normalized. So when I think of those 3, I'd say, one, we're -- we've been done for probably 2 years. Another one we're probably 80% done. And the third one, we're really not really started yet. The cash flow is getting better, but we're not normalized because we're not done with the transition yet. So I would say that if you averaged all 3 of those, I'd kind of -- I peg that we're probably 2/3 of the way through the transition.

Got it. So we'll still -- we'll look forward to seeing the cash flow inflection. That will be fun to watch.

Yes, absolutely.

So you mentioned that ACV total annual contract value is the metric to look at. Can you give us a sense of why that's the most important business metric during this period? I feel like oftentimes, investors are grasping for straws here as we see these business model transitions, maybe they'll look at revenue. Maybe they'll be focusing on cash flow, to your point, and you're not seeing that inflection. What's -- why is ACV for you guys, the metric you'd like investors to be focusing on?

So ACV -- think of ACV and ARR as being kind of interchangeable. We've used the term because many of our contracts are multiple years and the revenue doesn't always happen exactly in a ratable fashion. And so we've used the term annual contract value. The annual contract value ties exactly directly -- is directly correlated to billings. So think of billings and annual contract value, but ARR is, I think, a very similar measure. Any business that's in a recurring business, ARR is an important measure because it is the leading indicator for what should happen in billings and revenue in the subsequent year. But for a company going through a subscription transition, it is really the only measure you can look at because the revenue is obfuscating the growth as you go through that transition, the cash flow in a model that goes from perpetual to subscription will actually go negative. Growth rates will drop. So the business is very messy if you don't look just at ARR or ACV. Now as we finish the transition, I will still tell people look at ACV because it is still the best leading indicator. But during a transition, it's really the only indicator that you can really look at that will tell you what's really happening in the business.

Got it. I think that's really helpful and very clear. Speaking of ACV, it's been growing at a nice clip, I think, over 20% for the last couple of years here. As we look to '22 and '23, what are some of the growth drivers that you're going to be focusing on to accelerate ACV growth?

So I think we've proven to ourselves and hopefully to the investment community that we can sustain a growth rate around 20%. We've done it for coming up on 4 years now. So I think we've proven that we can -- we were a 12%, 13% grower before we started the movement to cloud and to subscription. So we -- I think we've proven something to ourselves that we can get to 20%. We have not yet proven to ourselves or to anybody that we can get to 25% or 30%. The market opportunity is certainly there. The product is there and our strength in those core markets is certainly there. The key is to -- the key of how to get there is really -- there are 2 very big levers. The first lever is productive ramped sales capacity. And the reason why I don't just say sales capacity is because they have to be it's not just hiring them, they have to be ramped to build the productivity in. We are not the kind of solution where we get pipeline booked and close the deal and bill all in the same quarter. That isn't our business. Our business typically has sales cycles that take between 4 and 9 months depending on the size and the complexity and the sophistication of the use case. Given that there -- there's some level of required sophistication around the vertical and the selling process. So if you think about the ramp of a salesperson to when they're productive, it can take 12 to 18 months. We don't want it to take 12 to 18 months. We want to make that better, but that is a key lever. We've made significant investments in sales and marketing over the last 2 to 3 years, and you're starting to see more of our sales team become into higher tenured buckets, which should then lead to the productivity that I mentioned. The second lever is system integrators. So system integrators in our business are a very powerful and influential lead and also closing mechanism. If you think about someone like Accenture, they have better relationships with our clients many times than we do, right. They're the ones that are actually in advising the clients on which solution to pick. And what to bite off first and how do you -- and so for us to think that we could sell without leveraging system integrators is really a much harder sell. So I think those are 2 very direct, somewhat operational transactions that we need to have, which is to continue to ramp the sales team, get the SIs more involved. And for any of you that have done channel checks with our SIs as I've seen actually, many of you share some of the channel check information that individuals talk about, you'll see the feedback. We're seeing the feedback from our partners, which the partners love that engagement. So there's certainly a lot more in the kind of behind the curtain that we have to do to drive increased productivity and accelerate the growth, but those are 2 really big levers.

Got it. Maybe can we double-click on the first one for a second. You talked about the sales -- ramped sales reps being a key driver to achieving this higher growth rate. Can you give us a sense of the portion of ramped versus ramping reps? And then also the impact, the great resignation and hiring challenges we've seen across the industry, the impact that that's having on leveraging that growth vector?

Sure. So I'm going to -- I'll give you -- this is a little bit of a framework that I think about. So if a company is not growing their sales team, so just take -- just to assume take any company, it could be Pega, it could be any company that just has decided for whatever reason that they're not going to grow their sales team. If it takes a year to ramp your sales team and you have normal turnover, the best you could probably hope for is having 75% to 80% of your sales team that is properly ramped. If the ramping takes a little longer, if your turnover is a little higher and/or if you're hiring net incremental then that number kind of comes down to where probably the best you could hope for would be to be between 60% and 65% of your sales team is really adequately ramped. That's -- to me, that's like the highest it could be just in a perfect world. We're under 50% because we've been accelerating our sales team so aggressively. That's a cost drag that's also a huge opportunity for that ramping to catch. And so that's kind of the situation for Pega. We had one thing that -- so first off, turnover, let's talk about that for a second. Turnover in tech across the board is higher. It's -- that's -- we're not immune to that. Anybody that you get up on stage is going to tell you the same thing. It's higher in engineering and it's higher in direct kind of customer-facing sales. not so much in some of the other roles, but those 2 specifically. We're not immune to that. Our turnover rates are probably 5 percentage points higher in 2021, and we expect it to be in 2022 from kind of the pre pandemic. The interesting part of that is that the -- there is an obvious cost pressure from that, right? If individuals are jumping between companies, typically moving for more money. They -- that would kind of force the supply-demand curve to work against vendors like us or others. However, that also means there's a lot of people in the market. And so the interesting thing is we have not had any challenge hiring and actually finding incredibly good candidates from companies that otherwise maybe wouldn't have been on the market. So the silver lining in the great resignation for a company like Pega is we're actually getting access to people from some of the brands that we would want to hire from and those individuals are more likely to engage with us than actually before this dynamic of -- so now how do we differentiate ourselves? We have to be the company that people in the market view as; One, having great technology; two, you can be very successful when you come to Pega; and three, we're the kind of company that is allowing as much as possible our teams to work what they want to work on, where they want to work on it and as much as we can when they want to work on it. The more we can be flexible with that kind of optionality, we can help to offset some of the hiring and kind of the turnover risk. So that's kind of our -- we will have higher turnover. We have had higher turnover. We're doing just fine managing through it. It does require more recruiting capacity in those times, but the talent is really good that's out there. I mean, it's probably the best talent market in terms of sourcing of candidates that I've seen in tech.

Got it. That's really helpful. And then maybe if we can touch on the second vector. You talked about a strong system integrator and partner relationships as another vector here. What have you changed over like maybe like the last 12 months or so, what have you been focusing on to kind of accentuate the impact that you have with that specific group?

So maybe it's helpful to maybe go backwards about 3 to 5 years. What Pega did maybe one might say incorrectly was we viewed the relationship with our system integrators as somewhat orthogonal to the actual selling of software. We would sell the software, and then we would say, and the system integrators go in and they implement it based on which one the client picks. And in some cases, that was okay. But in many cases, disconnecting those 2 really created an unnecessary friction between the system integrators and Pega. Sometimes they thought that we were hiding something from them. Sometimes they thought we wanted to do the system integration work, which by the way, we do not. Sometimes they may be wondered whether we were steering the work to one system integrator versus another. So what we realized was that there's no value to -- there was no reason to not engage with the system integrators kind of where they stand, which is right -- which if we go to Credit Suisse, who is the system integrator that you use, right? Do you use Accenture? Do you use Cognizant? Do you use McKinsey? Based on understanding that because we have 50 large SIs that have Pega certifications. So it's not like -- it's very unlikely that one of them wouldn't actually have a Pega team. And just working to make sure that we're doing what's in the best interest of our collective client and that we understand that they want to do the value-added change management implementation, technical work and really have that tight relationship with the program office, we want to sell software. So if we actually understand that we're very aligned and the client wants us to be aligned. So I think it was really quite an easy transition, probably one that we should have been doing for decades. But we -- because our solution was a software development kind of platform, you did have -- we had maybe a desire to be more engaged in some of the configuration that probably we need to be. So I think we're recognizing SIs are our friend, they actually play a very important role in the sales cycle. Quite frankly, we don't want to be in that business. That's actually not what we're good at. We can't get anywhere near the profit margins than the SIs can. So -- and it's not really core to us. So we're very selective with which engagements we get involved in.

Awesome. That's really helpful. Before diving into products here, can you maybe give us a sense of who you're seeing more often now in deals as your product portfolios evolve and as you've made this transition towards the cloud or towards subscription rather?

Sure. So maybe unsurprisingly, the competitive landscape is the same cast of characters, right? If we're in the customer relationship management space, we see the large CRM providers. If we're in the digital transformation, we see those same -- some of those same CRM providers, the ones that have platforms that tend to sell configurable use cases. We'll see them on the BPM side as well or on the digital process automation side. When you think about specific verticals, you also have the vertical layers. So some vertical players are very deep and maybe I'll use the kind of some of the ERP adjacencies or some of the workflow adjacencies that might be around executing certain activities across disparate systems. So we kind of have those 3 layers. One is the CRM incumbents, the big major players, they're right. We compete with them all the time. The digital process automation is some of those same ones, but also some of the core low-code providers but more like a ServiceNow or an Appian and Mendix or an OutSystems. And then you have the vertical players. So would we go against Guidewire in some cases, we would. Would we go against Veeva, yes, in some cases we would. Would we go against Vlocity, yes, we would. So there tends to be kind of like the vertical, the horizontal and then whether it's more of touching customers or more of an ERP adjacency play. So that's kind of the landscape.

That's helpful. So maybe on the product front here, can you give us a sense of how to think about Pega Cloud relative to Client Cloud?

Sure. One mistake that I made over the last few years was maybe mis-messaging that Pega Cloud and Client Cloud is something different that it is somehow there's a different churn rate, a different radiation opportunity, maybe a different unit economic profile for gross margin dollars and that couldn't be further from the truth. Interestingly enough, Client Cloud actually probably has a percentage point better gross retention. The radiation opportunities are actually almost the same in terms of is the ability to expand on one versus the other. They're the same technology. They're the same versioning. The only difference is that in some use cases, the client wants the Pega solution the control plane to be inside their virtual private cloud. So they want to run it on their version of AWS or Azure, GCP inside secured environment and Pega Cloud is on our cloud that we manage full service. So some solutions, which are more isolated solutions like, say, a marketing automation where it was coming through a URL, that would be much more likely to be on Pega Cloud. But if somebody was trying to orchestrate across a workflow across 15 different systems, that might be more likely to be inside a client's virtual cloud. So there really isn't any different from a technology or an economics, it's the same. However, I was trying to break them out in our investor information to really clarify a message that clients did buy under a Software-as-a-Service model for Pega. And that we were -- it was very relevant, and it was becoming a bigger part of our business, et cetera. And I think maybe the message that got mixed up was that somehow Client Cloud was less valuable than Pega Cloud and that you should really just focus on Pega Cloud. So I view them as a $1 of ACV is a $1 of ACV. It has the same unit economics. However, there are different use cases. And so that's probably one thing that I'm trying to continue to clarify because they're -- I could understand why people might view them as kind of old technology, new technology. They're not. They're the same technology. They're the same customer. They're the same unit economics, but the use cases tend to lend towards private cloud versus public cloud.

Got it. And so is it fair to say then -- does it matter to you where growth comes from, whether it's Pega Cloud or Client Cloud? And then do you -- I guess, can you touch on the gross margin dollar difference between them?

Sure. Gross margin dollar -- so if Pega Cloud is a 75% gross margin, right now it's approaching 70%, but let's assume the timeless model at 75%, the gross margin dollars are exactly the same. So the gross margin dollars at 75%, I think we can get Pega Cloud up closer to 78% to 80%. That's why I like Pega Cloud only because it gives me operating leverage on the gross margin. But the reality is I'll take whatever the client wants to buy because they're extremely sticky. They are incredibly right for up and cross-sell. So for me, it doesn't matter from a unit economic standpoint. There's one caveat that which is I need to be able to sell enough of both because there are use cases where it's -- we want to make sure we're relevant in both. We want to make sure that we have enough customer references to sell both because sometimes a client really needs one or the other. And so the ability for us to do both is incredibly powerful differentiator.

Right, giving them the flexibility. That makes sense. Can you talk a little bit about what is Project FNX? Maybe we should call it Project Scottsdale for today. But Project FNX, what is it and how is that initiative going?

So a little insight into the nerdiness of Pega FNX is FNX, right? So we made a function sign to basically, but that's -- we're a product company. So it's not surprising that we do those kind of little -- those little cute things. But so FNX is -- just think of FNX as we have a platform right now that is single tenant and largely was a very tightly integrated solution that worked brilliantly with large companies that actually needed the power of a unified platform, something that would be able to connect through APIs, be able to manage in a very, very sophisticated and powerful way. The first phase of this was to essentially move all of the services to be more micro services so that we could update and integrate with all the different operating system changes, and we're dealing with control planes and there's 500 different software applications that could touch Pega Cloud, for example, or Client Cloud. So we got to make sure that we're evolving with the technology partnership environment. So that's the first phase. We're done with that. The second phase of it is think about Pega being able to be white labeled maybe through the SIs. Maybe they create a managed service, maybe through a company like Boston Scientific that wants to offer a device identification subscription service to all the hospitals, right? So think about what we sell Pega is to help our clients solve their digital transformation needs. What FNX would open up is for us to sell through an ISV model to those companies so that they could run the Pega platform to actually execute a managed service, for example. That's an example of -- now what does that mean? That means it needs to have multi-tenant capability. It also needs to deal with data isolation, which we do really well right now. It needs to be constantly upgradable. It needs to be able to work with all the different emerging performance management tools, et cetera. So that's really where we're going. We're going from a solution that had really powerful relevance for the use cases that we sold to, to something that could be, quite frankly, a white-label platform that any company could build something on top of Pega to be able to get the same power of the solutions that we've sold to 700, 800, 900 large organizations over the years.

Well, it sounds like it's a pretty big runway ahead of it.

I think it's a very big opportunity.

Absolutely. Okay. Can we just quickly touch on -- so recently, it feels like financial results have been really solid, especially Q2 and Q3 during '21. But it doesn't seem like the stock has really worked to the extent maybe a lot of people thought it would have. Is there something from your perspective that investors are missing or some sort of message that you'd try to convey to them to help them understand the underlying performance?

Yes, it's a great question. And I've had enough conversations with investors to really know what is the core misconception that happened in Q2 and Q3. So for those of you that aren't familiar with the detail, our Q2 and our Q3 were the like light years ahead in incremental ACV add of any quarters that we've ever had. Like we had -- just to give you an example, last year, and total ACV add in Q2. I remember these numbers, we grew about $25 million to $27 million. This year, we grew almost $50 million. So it was a really significant difference in over the -- probably 70% growth in net ACV add. We took -- our constant currency ACV at the end of Q1 was 17%. Now we're up closer to 21%. So we've made a fairly big acceleration in the last 2 quarters. You would expect that given the -- give it market neutral that we would have had a positive reaction to that. The stock is kind of has been unimpressive in terms of the last couple of quarters. So I've had a lot of investor conversations and what is interesting is inside that significant ACV growth is a bigger portion of it is Client Cloud. And if you remember the conversation about Pega Cloud is SaaS, Client Cloud is where the client is managing it on their virtual private cloud. Many investors, I think, looked at those 2 as being Pega Cloud is the cool new stuff that we care about, Client Cloud, the old stuff that we don't. And so the narrative that -- if you believe that narrative, which is completely wrong. But if you did believe it, you would struggle to say, well, wait, Pega Cloud is decelerating and Client Cloud is now accelerating. It would look a little kind of different than what you had thought of or what you had modeled. And so I've talked to a number of investors and said: One, ACV is no different between the 2, unit economics at the gross margin dollar levels are the same. I don't care. In fact, when I look at the forecast, I don't even look at the mix. I'd say like $1 of ACV is a $1 of ACV. As investors hear that, I think most of them would say it's 80%, 90% of them kind of say, "Got it. I understand that now." The challenge is that we need to make sure that we are consistent with our communication that we just care about subscription ACV. We're not worried about that. We only disclose the 2 pieces just to make sure that we're transparent and people can see them. And I think that given continuing that conversation and really making sure our press releases and our invest, that we don't mislead to make it look like Pega Cloud is the only thing that matters. I think that is on us to make sure that we clarify that. And I think the response I've received from investors -- some investors say, "I just like SaaS better." That is some do think that. But most, I think, understand and appreciate that nuance. So I think that that's the only thing that I have seen as a disconnect between our performance, which is amazing over the last 2 quarters and the stock performance, which is less impressive.

Got it. So I guess as we look ahead into '22, what is the leadership team most excited about? And what sort of strategic plans and initiatives would you highlight as we look to see this continued momentum that we were just talking about?

That's a great question. The 2 that we are as a collective leadership team at Pega, probably most excited about is how much momentum there is around digital transformation. I mean, I'm sure -- I was at a conference in 2017, and I can remember -- I remember that at the end of the conference, an investor sitting down with me and saying, "Hey, you guys mentioned digital transformation. That's all everybody's talked about." That was 2017. I think now if you go through and listen to everybody, almost every company here probably says they're in digital transformation, right? So clearly, there is a lot of modernization going on. That is going to be years to come. So that's a great opportunity for us, and we are just squarely positioned to capitalize on that. And the second thing is, quite frankly, FNX. We've been a company that's largely sold to 500 to 1,000 organizations, and we're over $1 billion. And we've done pretty well penetrating those. Imagine if we could distribute to the end user through intermediaries like SIs or my Boston Scientific example or just pick the company, I mean everybody has value-added services that they actually supply to their clients. And just think about Pega being the kind of company that could be the kind of the white label, so to speak, underneath it. That really opens up an opportunity for us that we, to date, have not had. And so I think that being in the right space, the hottest space in tech right now and having this very near-term opportunity is pretty awesome.

That's really exciting. And I thoroughly enjoyed spending more time with you up here on stage again. 30 minutes certainly went quickly. So a big thank you to you, Ken. And then thanks to everyone for joining us. We hope you enjoyed the conference.

Awesome. Thank you.