Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Good afternoon, everyone, and welcome to day 1 of the JMP Securities Technology Conference. My name is Joey Marincek, and I'm part of the team software here at JMP. Really excited to have Pegasystems here today. With me is COO and CFO, Ken Stillwell. How are you doing, Ken?

Good. Joey, how are you doing?

Doing great, great to see you again in person. It's been a while.

I know. It's good to be back out and see people in 3-dimensional.

I know, right? So we have a number of questions we'll run through. And we'll leave some time at the end for any questions you may have in the room. But just to kick it off, those unfamiliar, can you give a brief overview of Pega and the problems you're helping solve today?

Sure. So Pegasystems is -- we sell enterprise software to the largest brands, think about the consumer verticals and largest brands that we all know, the large financial institutions, health care, telecommunications, et cetera. And what we sell is -- there's really 2 specific use cases in there. They're similar in terms of the way the work would flow. But they are different use cases, one being kind of a back-office use case where we help to automate work activity or workflows across disparate systems. And then in the front office, a different use case but a very similar problem, which is trying to connect disparate customer-facing systems to be able to help speed up activity interactions with clients. So we're really looking at scale transactions, where you're trying to automate and drive AI into the workflow so that you can try to get as a little human touch time and speed things up and try to automate as much as you can.

Great, super helpful. And overall, how's business, what would you say?

It's interesting. I think that the last couple of years with COVID has been a little bit of a kind of a -- I've used the example of it's like riding a roller coaster blindfolded, right? It's like there, it was like, "Holy s***, what are we going through," at the beginning. And then it was like, "Well, maybe this won't be as bad." And then you start seeing some of the disruption, the way selling happens, the way -- there are unintended positives and negatives from it. I think now that we maybe -- I'm not going to try to predict the end of the pandemic, I'm something like 0 for 5 on that. But like let's just say, once we get to another state of this, I think what we realize is that our value proposition and value propositions kind of that are offered by our competitors is much more relevant now than it was before COVID. So I would say in terms of our relevancy of trying to automate and be able to connect best-in-class systems to make for a kind of a sewn-together experience, very relevant. In terms of the actual kind of economic strength of the end markets, there's a lot of stuff going on right now as we all know. So that, set aside, I would say things have looked pretty durable in terms of the major markets. In fact, prior to the events of the last few weeks, I was starting to see Europe start to get a little stronger than they have been over the last few years. So we'll see what that really means. There's a lot of uncertainty now for a different reason. But I would think, in general, the buying environment has been strong and actually pretty resilient. And I think our use case is as relevant, if not more relevant, than it was 2 years ago.

Awesome. And then with everything going on, do you -- like what exposure do you have to Russia and Ukraine, if at all?

So yes, so we have a little bit of ACV or ARR in our business, a few million dollars. We don't sell in Russia. We don't have employees in Russia. We did. Before COVID, we actually did have an office, and we did have some employees in Russia that we sold to some of the larger banks and actually some of the banks that will -- that are likely going to get some strong sanctions. But don't ask me why, but I don't -- we certainly didn't see anything coming, but we decided to exit Russia about 2 years ago. So we have a pretty small amount of business there. A couple, Swedbank, Alfa-Bank, some larger kind of state-influenced organizations but certainly not anything significant.

Makes sense. And then let's move on. So how do Pega Cloud and client cloud compare? Can you sort of talk about the different use cases between and then maybe the economics?

Sure. So we have -- for those of you, just to kind of maybe level-set on, we have -- we sell a subscription offering that we manage or the clients manage. And you say, "Well, why would the client manage and why would Pega manage?" We would manage where the use case is one where the client doesn't feel the need to control managing the solution. The solution may interact with other applications that are outside of their kind of internal environment. Where the client may choose to manage it themselves is when they're actually interacting with a lot of internal systems, ERP systems and other operational systems. So I would be generalizing a little bit, but to say that some of the more back-office use cases or the traditional business process management use cases tend to lean more towards the client managing and some of the CRM-related ones tend to lean more towards Pega managing. And then when we manage, we sell that as Pega Cloud. When the client manages, we sell that as client cloud. The economics are interesting because I think that the market is conflicted on this because I think people that know Pega understand that our retention rates are high, that we have a lot of up- and cross-sell when clients manage it themselves. But I think the general theme is always SaaS is worth more. So I think investors tend to not look at the economics but just look at the actual go-to-market model. When you look at the actual economics, we have higher gross margin on client cloud than we do Pega Cloud. And when you look at gross margin dollars, if you kind of -- if you say it's the same deal, you get a little bit more annual contract value for client -- for Pega Cloud, excuse me. But when you look at gross margin dollars, it's almost the same. So if you think about the unit economics to us, gross margin dollars, they're about the same. But I do think investors tend to be much more focused on wanting us to sell as much on Pega Cloud as possible. But it's interesting, when I ask investors why that is, it's normally just because the assumption that you would have higher ability to up- and cross-sell, better unit economics and better retention. But that's actually not the case, they're the same in both.

Super helpful. That one comes up a lot.

Yes, it does.

So can you talk about the cloud transition just a little bit? Where are you at with that process? What do you expect the benefits to be once completed? And then how should investors expect that to show up in the financial results?

Sure. When we started the cloud transition at the tail end of 2017 and into the beginning of 2018, I kind of pegged that it would take 5 years to get it done. And so the -- I was off by a couple of quarters. It will probably end up taking about 5.5 years to get the whole way through to where everything is normalized from when we started. So when we started, we were -- 2/3 of our business approximately were selling perpetual licenses. When we end, we will be 95% to 100% selling subscription arrangements. So that's one shift. The second shift is once we're done with the cloud transition, you -- the model should work, so you should get back to operating margins approximately where you started. So everything else's the same. We ended in the kind of high teens of operating margin when we -- in the first year after the cloud transition, we should be back to those levels. The only thing that's a little different is we're selling a little bit of a higher amount of Pega Cloud than what I had originally modeled and we're investing at a higher pace for sales and marketing. And so those 2 factors could make you grow a little faster than when you started. When we were starting the cloud transition, we were growing kind of in the low-teens, kind of in the 12% to 14% range. Now we're growing at a little bit north of 20%. So those are some -- there's some moving pieces there. But just think about -- the business should operationally, from a margin standpoint, look like when it started when you're done with the cloud transition.

Super helpful. And then how do you think about your path to becoming a Rule of 40 company?

So some of our -- if you looked at our business for 2021, you'd say we're kind of in the low to mid-20s, right, in terms of the Rule of 40, Rule of 40 being the growth rate plus the operating margin, free cash flow, EBITDA, whatever. They're all approximately the same. So we're -- but when you actually go to the end of the cloud transition, if we did nothing different to the business, we would probably be in the low to mid-30s. Naturally, we expect to get better operating leverage from Pega Cloud. Our gross margins there are in the high 60s. They should be approaching 75% in the next -- probably next 2 years or so. And then the last thing that is a dial that we can turn up and turn down is sales and marketing. And we get a ton of leverage out of our product in our G&A and our gross margins are going to be up above 75% within the next year or 2 when we exit the transition. They're already in the low -- they're already, I think, 72%, 73%. So they're the strongest they've been since we started the transition. But sales and marketing is the real lever that we have, I think. It's a very fair question to say, is it worth spending this much on sales and marketing if you can't accelerate the growth rate? And I would say, no, it's not worth continuing to spend a ton on sales and marketing if you can't accelerate the growth rate. That said, I do think there is a growth. There is a -- we do have the ability to further accelerate our growth rate. But we're also not so myopic that we wouldn't understand the operating leverage we could get. So I think Rule of 40 for us and, quite frankly, even a rule of something more than 40% in a business with high retention rates with customers that buy -- constantly buy more, where our net retention rates, 114%, 115%. I think we have a tremendous -- our model is really built to be that very high margin. So we're kind of in an inflection point now where we're starting to evaluate that as we exit the subscription transition.

That's a topic I do want to touch on is how are you thinking about go-to-market investments this year that you intend to make? And then how do you think about -- how do you measure sales productivity internally?

Sure. So the -- so for 2021 and into 2022, the 2 biggest investments that we made in go-to-market, one we will continue to make, which is our customer success organization, right? We've got over $1 billion of ACV, ARR now. And we need a group focused on adoption, retention, cross-sell, up-sell. So that's an investment we will continue to make. And we also made an investment in our partner ecosystem. And that's been -- it's still early days, but I would say the -- and many of you have done channel checks and talked to our partners, so you can find this out for yourselves by just calling the big global system integrators. I think they view Pega as a different organization now in terms of the way we're interacting with and the way we market, trying to leverage each other in our -- in their practices. Of course, they want to sell more Pega because they have people that need to be billable. And that's their business model. So I think that's another area we'll continue to invest in. The third area was we've invested in direct selling capacity, sales reps, sales engineers and other participating members of the sales pod. That's the one that I think we need to be careful to dial up and dial down to make sure that we're getting good operating leverage. Then to finish your -- the question that you just asked there. The way that I think about sales productivity is I look at -- so similar to how some companies might use an LTV to CAC, we are -- we look at sales and marketing expense compared to the net growth in ACV. So it's not exactly the same calculation but it has a similar compare. And there's a lot of -- you can compare pretty easily to your competitors because they all produce pretty transparently that information. We are certainly not where we want to be on that measure. The biggest reason why is we have -- we've just been ramping a lot of new people into the sales system over the last couple of years. So that's the biggest lever we have.

Super helpful. That's one that comes quite a bit when we talk to investors. Can you discuss Project fnx? What is it? And why is it important? And what does the opportunity look like there?

So I'll try to hit this on a higher level. So there's 2 or 3 outcomes that we want from Project fnx. The first is we moved -- so Project fnx was not just one release, but it was continuum of releases over a few years. The first thing we did was we moved to a microservices architecture, where we can leverage Kubernetes. We can leverage -- we can run it on multiple control planes. Because remember, clients will deploy it on an internal cloud. So they may deploy it on Azure. We run it on AWS. We might also deploy it on GCP. There's also other versions, IBM has a cloud, Pivotal. So there's a lot of different options there. And our product really needs to operate in a way that we can push seamless updates and upgrades across clusters of clients. So that was kind of the first piece. The second one was we really wanted to ensure that the go-forward architecture allowed the power of what Pega was able to do in terms of stability of deployment but also created an environment where clients didn't get themselves in trouble, right? The problem with a really open architecture is it really isn't different than writing code. You can get yourself into trouble, it's hard to keep things up. And that's the way Pega was 20 years ago, right? Our products were difficult -- they were more like an ERP system, right? They were difficult to upgrade. They would take big cycles. And that's just -- we can do that with large enterprise clients. But when we want to not have 500 clients, we have 5,000 clients, that's not really an architecture that will support that. And then the third thing, which -- or another thing is -- and I would say this is one that we're not -- we're certainly not doing at this stage yet, but I do think there's an opportunity, is to really push through ISVs through the partner channel, so really be a multi-tenant cloud application environment, where other clients can deploy solutions and use us as a kind of white-labeling the platform, so to speak. That is not something that is part of our go-to-market for 2022 or even 2023. But that's something that could really change the game for us because that would mean we would be able to sell to anybody as opposed to right now, when we really are limited to sell to the top 2,000 to 3,000 organizations.

And on the product side, how are you thinking about product development currently? And maybe you can just give us some color on the product road map.

So there's a bunch of things that we think are kind of table stakes going for, certainly robotics. And we did an acquisition, I guess, it's been almost 6 years now, time flies. We bought a robotics company. That's completely integrated in with our platform. We've always had really good decisioning and AI capabilities, even back in the early days of Pega, through our Chordiant acquisition as long ago as 10, 12 years ago and then we've continued to focus on that. We actually did an acquisition for Voice AI, which is helping in the contact center and being able to translate conversational AI into -- so that's something that we think is really relevant. We've pushed really to be as open as we can with APIs to be able to essentially use Pega as an orchestration engine across different applications. And in order to do that, you really need to have -- we really need that kind of ties to fnx and making sure that our product will be able to constantly be current, work with all the new operating systems. Because as you can imagine, as systems upgrade, the APIs need to be upgraded, so we need to have that. So I think the most important thing for us is to leverage the workflow and process best-in-class that we have with robotics and with AI and be able to hit a broader audience by essentially being as open as we can to work with all the different applications. And everything we're doing in the road map ties to that mission.

That's great. Awesome. Let's dig into the competitive landscape a little bit here. What are the competitive dynamics between companies like Adobe, Microsoft, Salesforce, ServiceNow? And then how often do you compete against vertical software players?

So there's -- a company like ServiceNow is probably, I mean, the most like-for-like to us, even though interestingly enough, we don't see them as much as the other players. We just see them here and there. But even when we've actually even talked to ServiceNow, like we don't -- they don't see us as much. We don't see them as much in direct competition. We certainly compete for spend, of course, right, because we're going into some of the same departments but not on the use cases as much. Microsoft and Salesforce are the 2 largest. And it's an interesting dynamic there because we go head-to-head, very aggressive sales campaigns, but yet we also -- the 2 most common systems that we integrate with are Salesforce and Microsoft. So it's interesting that even though we compete so feverishly together in the market, we also -- we're also integrating with them. And there's a number of even collaborative projects we've done at clients with it. So that's an interesting dynamic. With Adobe, it's really just when you're in a digital channel, we might see them. We've actually partnered with Adobe as well in certain opportunities. So what's just an interesting observation for me is we partner with Salesforce to go against Microsoft. We partner with Microsoft to go against Salesforce. We partner with Adobe to go against Salesforce. So it's very interesting to see the -- and I actually think that's a healthy place for us to be because we don't want to -- we need to have some of those relationships and partnerships that might be relevant in different environments. Now when you go into the vertical players. So we will not do as well to a vertical use case where the client is not thinking about anything other than the vertical use case, right? That's it. If the client says, "I just want this one use case, and I don't care about expanding it into anything else," I would say everybody that I just named right there will probably not do as well. But most enterprise clients aren't just thinking about a standard vertical solution. They're thinking about, "I'm in a vertical, I have a solution, but I also have 5 or 6 more things that are almost kind of in the -- in line to land, so to speak, over the coming years." And that's where the vertical solutions end up being, having a disadvantage because they don't really have the broader applicability to being able to support what is not just a very, very vanilla vertical solution. Companies like Veeva that are very deep in a specific vertical, I think, tend to do better, in my opinion, against companies like us and our competitors. But I would say that a lot of the vertical solutions are very -- they're very close to COTS solutions. And that's -- that won't -- we have an easy time differentiating against those.

Awesome. That's super helpful. And I did want to dig just a little bit more on the customer engagement side. So like when going up against competition, why do you win? What do you say your key differentiators are on that customer engagement side?

So we -- if a client has a need to integrate and connect with other applications, if a client is trying to move away from -- move more to a digital solution, meaning people can go through URLs, whether they're in their home, in an office, wherever they are around the world, if they're trying to get human beings out of the workflow and trying to automate as much as they can and also drive AI so that you can use things like chatbots to be able to interact. Those are some things that would get -- would move the decision up to more of an enterprise-class solution. And when you get up to that level, there aren't that many, right? I mean, you're certainly less than 10, probably more like 5 that you're talking about in terms of the number of companies that could do that.

Yes, awesome. It looks like we have about 3 minutes. Are there any questions from the audience here? Yes?

Question then. Some people, on the private side, they own a very different version of the software, [indiscernible]

So you can do that. Some clients will be forced to do that because of their own internal testing requirements. But we do have lines in the sand that we draw, where we force clients to upgrade on certain aspects of the product within some period. And we'll only allow them to be on a certain version. But that -- but it is, I would say, very common that -- and even -- quite frankly, even in Pega Cloud, you have the ability to hold back certain functional updates. And some clients, because of the significant compliance, they will ask us to say, "Hold back, we want that solution to be 90 days or 180 days live before we actually adopt it." So we do have that flexibility to hold back for clients. And it's interesting, like I never really thought about that until I've lived it. There's a -- think about banking, health care, they go through significant security and control testing. And they just can't have -- a lot of times, they can't have patching or an update just push through until they have proper time to test it. That said, we do have a cohort of clients that actually test in development with us. So they can actually do some of the -- so when we actually go live with something or general release, we typically know like here's how you're going to comply with HIPAA. Here's how you're going to comply with first -- so that's TrustedSec, et cetera. There's a bunch of ones, but they do have that option.

Yes?

Could you talk about your real-time intelligence offering and how -- maybe you're seeing demands increase [indiscernible]?

Yes, that's probably the most common, I would say, thing we hear over the last 3 to 5 years is that clients have all this data, whether it be in Pega or it be in other systems. What Pega does is Pega has a case. What the case does is it's -- think about it, it's in a container that we can go grab data, store it. And then because we're storing the data and we can associate cases, it gives us the ability to put rules and logic and AI against it at a level that you can't do it with like kind of a database structure, so -- at least from a speed standpoint. So huge demand for that. And where it's most common is -- the 2 that I've seen the most is one is in a channel when a consumer is coming to a website or advancing in a digital discussion, using the information to be able to drive the discussion. So it could be you're asking for a credit line increase on -- you can actually be texting with a chatbot or you could be on a website, and what does it render and what call to action does it give you? And what does it try to propose that you consider? And then the other place is a little bit, I would say, it's kind of more on the process side. And I would say it's really around kind of being able to make decisions in a workflow to either skip a step, intervene because the workflows are set up in a structured way. But based on learning things, you might say if the following things are true, you don't need to ask for Ken's approval with step 5 when typically you would. So some of it is more on the digital with the customer. And the other big one is trying to essentially not waste time getting humans involved in the workflow as much as possible. Sometimes it could be skipping a step with a client because you might be able to go grab that information from somewhere else and not actually ask them for something. So those are the 2 most common at scale that we're seeing.

All right. Well, it looks like we're out of time, but we really appreciate it, Ken. Thank you so much for your time. And thanks, everyone, for joining. Appreciate it.

Thanks, Joey. Thanks, everyone.