Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Hey, everyone. I'm Pinjalim. I am part of the software research group in JPMorgan. And it's my pleasure to welcome Ken Stillwell here. He is the COO and CFO of Pegasystems. Ken, welcome to the conference.

Thanks, Pinjalim. Great to be here.

Great. Why don't we start with a little bit of an intro about yourself and maybe you can give a few lines about Pegasystems as well for people who don't know about it?

Sure. So I'll start with Pegasystems and then a little bit of my experience here. So Pegasystems is a leader in digital transformation initiatives around what is what we call end-to-end work automation. What that means is if you think about either back office or front office use cases where you're trying to execute some type of work, it could be onboarding a customer, it could be originating a loan, it could be dealing with a customer service ticket. It could be transacting in ACH through a banking system. It starts with an initiation of some type of an event, and then that event is managed until completion. Sometimes through one step, but oftentimes through numerous steps and distributed systems. And what Pega has led for 40 years is really helping our clients manage that type of action through all of the steps in the workflow to an end result of a completion of that task. Some of the things that differentiate us are we use -- we have robotics native into our workflow, which means that we have robots that actually can determine through our AI capabilities, which is another differentiator, be able to make decisions and take actions that a human would otherwise have to take. So if you think about the world that we live in right now, which is a world that involves inflation, difficult finding labor, even when you find the labor, the labor is distributed and you've got a number of certainly in large organizations, best-in-breed application suite that is not naturally connecting to each other. So what Pega helps to do is to solve all of those problems. I've been at Pega for -- actually, it will be 6 years next week. I came in as the CFO. I became the COO about 2 years ago. I'm responsible for, think of my role as everything that isn't building a product or selling a product. And pretty much everything else that includes cloud operations, everything in the kind of finance, legal, IT, business strategy, corporate development, et cetera. But the reason my kind of -- my taking on this expanded role a few years ago was really around Pega Cloud. I'm responsible for our Pega Cloud business. And when we moved into the cloud business, we went through a fairly significant subscription transition that I had led for the last 4 or 5 years.

That's great. I want to dig into the Pega portfolio a little bit, right? It is pretty unique. You have the low-code new code angle, the workflow automation platform on one side. You have the CRM packaged apps on the other side that's built on top of it. Help us understand what part of the portfolio do you see is kind of the strongest, right, in terms of resonating a lot on customers? And maybe which part you kind of are coming up the curve, the maturity curve, right?

So Pega, if I'm honest with myself, I would say the area where our solution is probably less relevant is kind of the out-of-the-box solution use cases. So something where you might sell a very standardized, say, like outbound e-mail campaigns, where it's really largely out of the box with slight configuration, you really get the benefit of a multi-tenancy kind of environment where clients are typically not paying you that much, but you need lots of clusters of clients to be able to get that model efficient. That really is not what Pega does. What Pega really has started with was in the enterprise, and we still are almost exclusively an enterprise companies. So if you think about where we're trying to kind of navigate ourselves from this, what was a bespoke enterprise business process management platform to where we are now, which is a -- maybe a kind of you're configuring the last mile of the application, but it's very highly a lot of reuse highly scalable, you can cover more common use cases, and we're moving into a world that would allow access to that robust platform in a traditional multi-tenancy environment through ISVs, through partners and in some cases, through us actually managing certain applications in that traditional multi-tenancy cluster, but we're not there yet. I mean that's kind of the future of where we would hope to be, but that's probably still a number of years away. Where we are now is really the robust common use cases on our platform that we've been -- that's where the kind of the bulk of our selling activity is. Very little of our activity is the traditional, I have a unique bespoke problem, and let's go customize a solution. We still do have some clients that like to use our platform for that, but most of our clients are really solving problems that we see every day.

Understood. The other point I want to touch upon was, I think you kind of alluded to it, the tight labor market, right? And automation, you probably said the word many times in the last 2 minutes is a big core tenet of Pegasystems, right? So in this environment, would you say that has become kind of a tailwind for you, there is a tight labor market, there is a shortage of skilled labor. Is that coming up more and more in the planned conversations in here or in Europe?

So it's interesting. Before inflation started to rear its ugly head for all of us. And really, I would even say on the beginning of where we started to think about this great resignation and kind of waking up after COVID and all of us scratching our head, like, where did all the workers go, right? Like they were here 2 years ago and somehow they're not here now. There was this trend with our clients saying, listen, good times or bad times, we're too reliant on human interaction. We're too reliant on a person getting on a phone and one-to-one answering that. It takes too long. It's inconsistent experience for the customer. Sometimes they get a good customer service experience. Sometimes they just hang up and call back, right, because they don't like the person that they had on the phone. Other times, there's 180-minute wait time. So terrible experience. Now people are saying, well, I want to go through a digital device. I want to walk into a store and I want the experience to be relatively consistent. We've seen our clients move toward a where -- we need to figure out how to be able to support scaling interaction with our clients, both on the customer service side, also inbound marketing and in the selling channels, and we need to do that in a way that can scale. Sometimes people say, well, let's use robots. Well, robots have a high probability of air, right? And that's not -- that's -- when you're trying to hit highly engaged customers, remember, these are customers that are already talking to you. They're already a client. They're someone like John was talking from AT&T earlier that some of you may have heard, clients that are really connected to the brand. So you can't just throw them to a robot, right? So that's not going to -- you can use AI, but AI to do what, right, to guess what the customer is going to do. You still have to have a way to manage that customer experience. And so what our clients are trying to do is they're saying, I need less people. I have less access to people, but I've got an increasing amount of engagement that I want to do with our clients, how do I marry those together to be able to create seamless workflows across the customer journey in a way that I'm not dependent on individuals actually getting on a phone or stepping in front of a customer. Some companies have done this really well over the years and some have a tremendous transformation that still needs to happen. And so our clients now are looking at and saying, okay, so let's say we hit some soft times. Let's say that we have inflation. We got a tight labor market. Digital transformation becomes the thing you need to do to be able to deal with. I got to take cost out of my business. I've got less employees that are going to be -- that I need to engage, and it's harder to access those employees. And then the last point is everyone's distributed now. We've all heard the -- seeing the trends of nobody goes into the office 5 days a week anymore. What that is really transitioning to is it's almost kind of a follow the sun model in perpetuity where you -- when somebody gets up in Lisbon, where is the person that can actually support that? Or where is the system or the bot or the process that's automated to support that consumer as opposed to having very big processing centers that would constantly move around based on the cost of labor. And that model is really dead.

Yes. On that point about digital transformation, I think your -- you have come up with the Pega voice AI, which was the Qurious acquisition, which has a fantabulous demo. I've seen one of those. And I think your process fabric is also out, I believe, in the latest version. How do they kind of -- help us understand what is Process Fabric, where does it fit in, in this discussion?

So think of Process Fabric. The way to kind of maybe simplify the perspective here is, if I am an employee or a manager working in company X, I have a number of applications for which I'm engaging either engaging with our clients, engaging with our supply chain, engaging with our employees or just managing activities that might happen through the organization. Right now, if I want to do that, I'm actually trying to log into different systems or I'm trying to create kind of a custom almost a kind of a tile view of like if you think of the old days of like Lotus Notes where you kind of had different applications that you could try to drill into for different activities. Think of Process Fabric as a dashboard that integrates all of the activity. It shows you what's happening with everything that you've kind of subscribed to or care about. It might show you actions or activities that are on your to-do list. It might show you your team and how efficient they're progressing against certain KPIs. It would also show you things that got hung up right? We're having a problem here. We have the same issue that's happening. So it's just -- it's a way to integrate all of the different best-in-breed applications and show where things are in the kind of pipeline and be able to almost tell you when you need to engage or when you need to kind of drill down onto a certain issue. So it's really -- I like the example of like that dashboard of everything that's going on within your area of exposure.

It's like a control center is actually...

And there's companies like New Relic and Dynatrace and Datadog and Splunk to do this for like performance management applications, that's kind of analogous to that.

Right, right. Okay. I want to change gears a little bit and talk about the demand environment, right? There is so much volatility, obviously, in the stock market, but then you have the macroeconomic problems, you fearing interest rate hikes. -- you have the geopolitical risk in Eastern Europe. How are you thinking about -- or how are your reading, I guess, the demand conditions, right, as you go into June? And what should investors kind of expect in the second half from your point of view?

So it's interesting. I heard someone speaking earlier today and the way they framed it really resonated with me, which is we aren't seeing demand issues with our clients right now. Why is that? Well, probably because most of our clients are dealing with this digital transformation initiative and trying to manage through some of the other dimensions of this that I just mentioned, which is tougher labor market, higher inflation, got to get cost out of the business. Digital transformation is certainly a way to help get through that. So we haven't seen anything yet. It wouldn't surprise me in the future if we saw the general demand environment change if we -- if we do not kind of get this inflation thing under control. And if we do -- if we are able to get it under control, then that -- I would imagine that all of us will be thankful for that. But right now, we're not really seeing any issue with our clients. We're not seeing an expansion of sales cycles or delayed closings or clients shutting projects down. I mean that's normally -- companies in enterprise, my experience has been you typically start to see some of those early signs of people canceling meetings or saying, let's -- and that does not appear to be happening really in any part of the world, except for maybe a little bit in the eastern part of Europe, where they're just I would say, very distracted, obviously, and also have some supply chain and energy kind of urgency that's a little different in that pocket. But if you take that isolation away, and that's typically manufacturing heavy, we don't have a big part of our business in manufacturing. If you look at the rest of the parts of our business, it feels, I would say, relatively consistent that it's been for over the last 2 years.

So it's all systems go, but we don't know about it later out.

I would say I am just -- I'm more cautious because I feel like everything that's going on, there's higher risk of disruption for all of us, but we haven't seen it, but I'm still cautious.

Yes, that's probably fair. The other point is, which is probably the biggest topic of discussion around Pega in the stock right now is the litigation with Appian. I don't know how much you can talk about it, but maybe is there anything you want to talk about just to clear the air. Have you -- is there any change in the business strategy from that point of view? Just touch upon all those things.

Sure. So I'll start with saying our business strategy. What we plan to do in the coming few years is unchanged by the actions that with Appian. Obviously, there is distraction. So I mean we are -- we have to make sure that our clients and our partners and our employees understand that this was a civil this was a civil kind of issue between 2 parties. It doesn't relate to our product. our intellectual property. There's no restrictions there. This is something that is an unfortunate reality of our legal system, which is you could have situations where the executives of the plaintiff admittedly cannot actually point to any of the facts around what they -- what we allegedly did, can't show that we did it to the product can't show $1 of damage, but somehow these things happen. So I'm not in any way minimizing the distraction risk that this has because it is. It's -- I'm talking about it right now, right? I'm talking about it with all of our investors and some of our clients. But I would say the substance of what it is, is less concerning to me, right? It's more of the -- just the unfortunate nature of getting kind of caught in something like this. The reality of what needs to happen right now and if you kind of use the analogy of like kind of lemons into lemonade, this has never been a better opportunity for us to engage with all of our clients. I mean it's actually -- it kind of sounds weird to say, in fact, someone said that to me a few weeks ago, and I was like, that's an optimistic perspective on the distraction. But the reality is every single client is accessible to us. And interestingly enough, and I've been in a lot of them, when you go through and you have those conversations and you actually express here's what's factual about what did or didn't happen. It's actually been a really good outcome actually to get through that discussion so that our clients are not just reading a press release and the marketing of that and getting caught up in that. So I think it's distraction. It's a distraction. It's unfortunate. We have to use this as an opportunity because our clients need us now more than ever.

So just to double click for one second here. You talked about distractions, which is a word people sometimes get freaked out it. Is there -- help us understand, I mean, with that -- you just said the demand environment is good. You're not seeing anything, but there could be some distractions, right? Should people be conservative on the ACV growth guidance that you had for the year?

So I think the distraction -- my read on it is the distraction is a little bit more for our employees and our partners than it is for our clients, right? Our clients see these things all the time. I think they are actually more used to disputes between competitors than maybe our teams are. And so that's why -- when I talk about -- that's really where the focus is, is really just keeping people focused on the prize now, will a deal slip because of communications that happen concerning how -- absolutely, there is that risk, right? I would say that isn't what I'm seeing now. right. When I'm not -- what I have not seen with our clients is people saying, "I'm not sure if I want to buy with Pega. Now there's a really important reason why that may be, though. Most of our bookings are not with new logos. Most of our bookings were in existing logos that already have significant investment and significant momentum with Pega. And so I would say that scenario is a little bit easier, right, to continue to progress versus a new logo that may not know who you are and you're trying to initiate a campaign around. So I think from that standpoint, that's maybe a little bit more a little bit of a better scenario to be managing through the quote distraction.

Maybe touch upon that, the mix between existing new how much of the ACV growth is driven by existing versus new today?

So it's actually increased over the last 3 years. About 3 years ago, we used to get somewhere between 65% and 75% of our growth of our sales bookings. Think about the way a salesperson is commissioned, and that's growth in ACV. That was about 2/3 to -- approaching in a high year, 72%, 73% came from existing logos and exists someone that we already did business with. If you go back the last 2 years, and some of this was probably COVID-related, that number has been approaching 75% to 80%. So we've actually moved into kind of the last 2 years anyway, that more of our bookings have actually been coming from our existing logos. Now there's a couple of factors there. One, I think is the COVID effect, which is when you're selling virtually, it's a lot easier to sell to people that know you versus selling to people that don't know. I think that's an obvious realization. The second thing is that once you get enough logos that are large, you can imagine the amount of white space that you can sell into your existing logos. So us going from 500 logos to 800 logos is not a 60% increase in opportunity, right? It could be massively more than that because you still got all your opportunity to go sell across all of your 500. So I think there's just -- when us getting from 800 to 1,000 new logos is really not going to get us there on our bookings. It's going to be to increase the average spend of those 800 logos that have already done business with Pega. And then the third thing is that -- if you think about where digital transformation is largest, it tends to be on the higher end of the food chain. Companies that have more scale that have divisions that have geographical growth that tend to use different best-in-breed systems. So that -- I think all of those reasons are the reason why our -- as we've grown and our growth rate has accelerated, it's actually went into the larger companies.

Got it. Again, shifting gears a little bit. The go-to-market side, right? You have Hayden leave earlier this year. Help us understand where does the go-to-market organization sits today in terms of structure. You didn't miss a beat in Q1, of course, the ACV growth actually accelerated in Q1. So at this point, is it fair to say that all the distraction from that point of view that Hayden left, right? all the distractions are gone. It's more stable apart from whatever is happening on the litigation side, but other than that.

Yes. So I never -- I was, I would say, more optimistic around the distraction not being great around Hayden leaving. The reason why is -- much of what Hayden was doing, by the way, I would have rather Hayden not leave. Like I mean he was -- I enjoyed working with him. And just having someone leave it's not something that you want to have to -- especially at the beginning of the year. That said, most of the initiatives that Hayden was driving was not in the core of us selling to our existing logos with the exception of one, which was making sure that our partners were more deeply engaged in those selling products. So I would say the thing that -- some of the initiatives that Hayden was really more deeply involved was things like going into new markets, trying to expand new logos, trying to actually get partners to sell for us, which is still was still objectively probably still a few years out anyway. If you think about the core of us selling to our existing logos and leveraging the big SIs to actually help us sell more densely into those organizations, those were things that I think have really been quite easy to transition. What we did was we did organize differently. Before all of go-to-market reported to Hayden, and we decided that instead of replacing Hayden that we wanted to separate the activity into 2. Kind of the -- think about it as like the pre-deal closing and the post deal closing. And the reason why that was so important for us is this is a gentleman named John Higgins, who came over from one of our larger competitors a little over a year ago. And what John's amazing at is really building out that post-sale customer success and really that's everything from getting enterprise architects in with the client to think about new projects and putting in the way the CSMs engage on adoption. And then also, we have him as leading our partner initiative as well to keep our partners tied both on the preselling activity, but also post sales to make sure that they're looking for that next project. They're looking for the next way that Pega can help us. So that's the way we separated our go-to-market was kind of pre-deal closing and kind of -- and that's been before Hayden, we were geographically. Everything was centralized, everything was under one leader, but we had geoleaders. So we had some differences between the geographies. And if you think about if we're selling to companies that are global, really you need the connection at the account level. So we -- now we have everything connected at the account level, but we just have a kind of almost a preselling and a post customer success.

Got it. Got it. I want to touch on Pega Cloud, which kind of has accelerated last quarter. It was a big topic of discussion last year when I think it seemed like you hit an air pocket, it slowed a little bit. But I know you're focusing on total ACV growth but it did accelerate in Q1, right? So help us understand if you look back, I mean, what had happened and why did you hit kind of an air pocket in cloud? And how should we think about that trend going forward? Because now I think you're clocking in something like 67% of your new commitment is cloud now? And it seems like Q2 would be similar from what you had said before. So help us understand the trend going forward as well as what happened last year?

So first, let me start by saying, and I think I've been consistent with this. All ACV is good ACV for Pega, right? There's that just because somebody doesn't buy using Pega Cloud, the reality is the use case is the same. The client just chose to manage that private cloud themselves. They're still just as much upsell and expansion, the retention. So as much as from an economic standpoint, both clouds are fine. To me, that's all good. I think that there was -- if I reflect back, we had very steep momentum with Pega Cloud about 3 years ago where just -- there was just a lot of momentum. And then it became -- then we kind of hit this point where the major cloud vendors started to sell these commit to consume contracts, Google, Azure, and AWS. So they basically came in and they started to go to our clients and say, "Listen, if you want to deploy Pega Cloud, you want to deploy Pega on a cloud." That's great. Let us sell you the cloud, you go buy Pega and you manage it on top of that. So we went through a little bit of a realization or kind of an awakening with our customers that if you wanted cloud, you didn't just have to go buy it from the vendor. You could actually quite frankly, it could go to one of our SIs and they could manage it on Azure, on GCP, our Pega Cloud is only on AWS right now, just to be clear. So I think there was this shift a little bit to clients. And I think now what at least for this past quarter and the quarter that we're in because I think Q2 feels like it could be 67% or even higher, like it feels like there is I think maybe there's a combination of a few things. One, I think our sales team is much more proficient at selling Pega Cloud than they were 2 or 3 years ago. And I think now enough clients have it, and there's almost like a realization of the maturity of it. And there's -- and I think that's kind of almost -- I feel like it's almost a step function, right? We had a ramp to a certain amount. Maybe we're actually starting to see that next step up to a new normal. The negative to that, and I'm saying negative, it's not really a negative, but the negative is that means you have revenue headwind in the current -- in the year that you do that, right, which actually means and you have EPS headwind. So just that is hard for me to get my head wrapped rather than just to continue to reinforce it with everyone to say, listen, if Pega Cloud ends up being 60%, 70% like it was 67%, then there's -- our model for this year is kind of a little bit on its side, right? Because we had modeled this year at 52% Pega Cloud. So going from 52% to 67% for 1 quarter, it hurts, but to do it for a whole year, that's a relatively big move. So that's the part of this that when I say like the negative, it's not really a negative, but I just have to process that. And try to give as much information about what I'm seeing. That said, I don't know it. I mean it could go to 80% this quarter. It could go to 50%. I mean it's really a wildcard because clients buying is just not as visible to which way they want to go.

Yes. Yes. Understood. Okay. I wanted to open it up to audience in a bit. So if you have questions, feel free to think about it. I'll just ask one more. It seems like the last quarter, it sounded like there is a little bit more focus on profitability. You were talking about more profitability you brought up. Is there a change in the thinking going to this a little bit, maybe slower economic environment to shift more towards profitability?

So the timing -- the timing looks like that was tied to maybe inflation and so it really wasn't -- the timing is more tied to us ending the subscription transition. We -- when we were in the middle of the subscription transition, there was messaging that I wanted to be very careful of sending not just to investors but also to our employees right, to be saying, let's get -- I don't want to distract you from actually getting through the cloud transition. Let's get to the subscription transition. Let's get to the last year which we're now approximately a year away from ending it. That's when the natural profitability should start to normalize. And so what I saw was that coming, and I saw we had a little bit over invested in go-to-market and weren't getting the higher growth from it in the face of what would be a harder economic climate to accelerate growth than what it was a year ago. So the combination of those things really kind of made me realize that I need to be very, very disciplined with my speech. I need to make sure that internally and externally, this is the time to now see our profitability, not only get back to where we were, but to actually leverage it to get better because we want to be a Rule of 40 company. So the timing was not completely tied to the economic. But certainly, I would say it was maybe reinforced based on just the reality of what we saw and the fact that we've been a 20% grower it's -- when you grow for 20% for that many years, you kind of -- it's hard to say, I'm just going to snap my fingers and be a 25% or 30% grower, right, because it hasn't happened.

Yes. Yes. I want to open it up to people if anybody has any questions, please raise your hand. Okay. Let me double-click on that last point again. Rule of 40, I think your definition is ACV growth plus free cash flow margin, if I'm right. So if I think back before the transition, your free cash flow margin was in the teens like 16%, 17%, right? You're ending the transition in calendar '23 about, so should we expect that level of free cash flow margin to be apparent in the business in calendar '24? Or as you're pivoting more towards profitability, could that be actually even more than mid-teens or...

So I think there is, in '24, we are going to do what we can do to be a Rule of 40 company in 2024. And the way that I've kind of framed it is many of our investors say, well, here's where you are now. There's a series of things that need to happen for '24 for that to kind of be certain in '24. So naturally, these are forward-looking comments that I'm making. But we see a path to be able to be a Rule of 40 company in 2024. And the way we see that is kind of more in the like kind of 20% to low 20s to high teens to 20%. So just kind of call it 20-20, just to make it up. Just to draw a line in the sand. And that would be slightly more profitable than what we were when we started it and growing slightly faster than when we started it. So that's kind of our -- that's our stake in the ground that we're working toward.

Okay. We have 1 minute left. Any more questions? Okay. I'll probably ask you last one then. You have your user conference starting tomorrow. You have an Investor Day coming up. What should -- I think Investor Day is last next week, right?

Yes, next Thursday.

What should people kind of expect? Do you -- is there a big production announcements in the user conference? What should people expect?

We always use PegaWorld as an opportunity to highlight some newsworthy events. So I would expect that. I would expect product, I would expect some partnership announcements. And I would -- for Investor Day, we're going to really just reinforce and anchor what we're doing with the product how we're helping our clients win with the solutions that we sell to them and how that will translate into our model update, and thinking about kind of the future of our model update and give a little bit more color around how we think about this role and also the impact of Pega Cloud so that you can kind of get a little bit more sensitivity of Pega Cloud within a year and how to think about how Pega Cloud would impact or not impact revenue in the current period.

Okay. With that, we're -- let's wrap it up. Thank you, Ken for your time.

Thanks.