Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

All right. Welcome, everyone. I'm Ken Wong, software analyst here at Oppenheimer & Co. I'm pleased to have with us Ken Stillwell, CFO, COO of Pegasystems. We're going to probably go through about 30 minutes of fireside Q&A. At that point, I'll take a quick pause and see if there are any questions from the audience. If not, I will continue down the path of asking questions. So yes, with that, I think we'll get started. Ken, welcome. Thank you for joining us.

Thanks, Ken. Good to be here. Appreciate it.

So I'm sure that you've been getting this asked quite a lot of you. Macro is top of mind with pretty much all investors today. So I guess first off, I'd just love to get maybe a quick refresher on what you've been seeing in your business. Kind of what areas are you seeing some resiliency? Where are you encountering some pressure as we exit Q2?

I think in general, digital transformation, which is the space that we play in, tends to continue to have a lot of momentum because as our customers think about staffing levels, retention of employees, turnover, the Great Resignation, efficiency, all these things play into how can systems help you operate and run your business and automate more things to be able to not get rid of your employees, but to be less reliant on human beings being the way that you scale your customer base and your interactions. Now that said, we're not immune from seeing and hearing about the angst in our customer base and in our peers about what the future looks like. What's -- is this a recessionary environment? What's going to happen over the next 6, 12, 18 months? That said, we haven't seen clients react to that, but we anticipate that there will be some weakening, extended sales cycles, et cetera, as we get to the back end of the year. People rethink about 2023 and what their budgets are for '23. I mean most clients are just starting their planning cycle right now, right, for the 2023 if they're a calendar year fiscal company. So I think we are cautious. We haven't seen overreaction from our clients. We've seen pockets of concern, certainly in the East. Countries in the Eastern part of Europe are certainly on more heightened alert around the instability of energy and supply chains and that causes. I would say Asia Pacific and Americas are watching but probably indirectly impacted. So that's kind of my -- what we are seeing.

Got it. And I guess as you evaluate some of the KPIs or just the key business trackers, like what -- I guess, how would you envision that some of these headwinds could bubble up? I'm sure you guys have at least started to kind of think through where it might surface first. I would love to just get a sense for, what are you guys telling investors in terms of signs of potential erosion that are usually things that you guys keep an eye out when evaluating your business?

So I think I'm going to draw an analogy from the early stages of COVID or the early stages of the pandemic to a less robust economic environment, and I'll use it that way. You can read that as a recession or just slower growth or less certainty. Things -- I think vendors -- customers and vendors are responding typically in a way where they anchor more toward people that they know, brands that they know, clients that they know. That happened in the early stages of the pandemic when people couldn't travel. They couldn't interact physically face-to-face. You tend to gravitate towards the faces that you know, the people that you use to interact with physically. I think in a recessionary time, it's not dissimilar to that. It's a situation where customers are going to look to their existing vendor base. And they're probably going to be a little bit more scrutinizing net new vendors in that environment because they're already reliant on their existing providers, their existing partners. And so it's expanding their spend or their reliance on the existing relationships that they have as completely rational. So I think what that means is for companies like Pega, new logo acquisition at a time like that is harder, less efficient and quite frankly, less -- more risky in terms of a growth strategy than actually really focusing on where you can mine and improve the relationships with your existing clients. So that's kind of how we're thinking about the situation, the impact and how it might play out. There are going to be some verticals that, of course, are impacted more than others, but that's no different than any day of the week, right? There's always verticals that are impacted by market events, by global events. And so I don't think that there's a particular vertical or region that over the next 24 months, we think is going to be materially disrupted in a way that other ones are. I think we just need to manage our business and primarily our existing clients, which we get over $1 billion of recurring spend from, and continue to enrich those relationships because it's just -- it's a tremendous opportunity for us in terms of the amount of increased investment they can make with us and we can support for them.

Got it. And I guess without trying to turn this into too kind of negative of a Q&A, maybe I'll just pivot quickly in terms of -- earlier, you touched on digital transformation with customers. Look, I think we all recognize that the value of your platform and driving greater efficiencies with low-code and accelerating digital transformation in terms of just helping customers improve processes is undoubtedly a productivity driver. I guess, what are you hearing from customers? Where are they focused in terms of trying to extract some of those efficiencies? And how does Pega get involved? And what's that opportunity look like near term, maybe more medium term? Like you said, there's maybe some planning for '23 already from some of your customers.

So I think one of the most interesting things that I'm seeing around digital transformation is this -- and I think this will converge, and I think even -- you're even starting to see it converge. But there's this, I think, incorrect concept that things like process mining and AI and robotics, things like that are different than digital transformation. They're almost different segments. They're not. They're enablers of digital transformation. And when you think about them as separate stand-alone spaces, you really minimize their value. And so when you think about what you can do by incorporating those capabilities, those -- almost those features, in enabling digital transformation, why would a client do that? Well, they want to be able to deal with increased scale. They want to automate as much of that scale so that a person doesn't need to do something. They want to have clients go right to the activity. They want clients to get the offer they want. They want clients to self-service. They want the system to solve the problem through diagnostics and automation that a human doesn't have to guess or, in a clumsy way, transfer you between 4 different CSRs as you try to solve what might be just a simple address change that someone is trying to deal with. You want that -- you want to kind of miss -- you're taking unnecessary interactions. You're speeding up the experience for customers. You're automating things across. They're using AI and process mining and the like to be able to see things that are going to happen and course-correct, take those obstructions out of the way, automate, auto close, auto initiate, auto fulfill. Those are all things that don't -- they're not about -- it's not about taking heads out of a company. It's about optimizing it so that you can scale in a more efficient way. And I think that the biggest mistake the industry makes is acting like something like robotics or process mining, for example, are these stand-alone spaces. They're not. Maybe they are temporarily until they get adopted into kind of the digital transformation kind of work stream, so to speak. But it's got -- they cannot be disjointed. They're a value-add to what is a process that is -- or excuse me, that is a momentum that the industries have to be able to optimize. And I think -- I worry sometimes that a new feature becomes like a new segment. It's not really a new segment. It's a helpful way to automate something that has already existed. So I kind of been watching the -- process mining is probably the perfect example, right? Why -- what -- where is the value in process mining? It's not just streaming the data, it's what you do with the data and actually how you can optimize what you do with the data.

Got it. Super helpful. And I guess as you think about that construct and that maybe initial confusion, I guess, how far along do you feel you are in terms of getting customers to understand that? Has that been at least an initial bottleneck? And potentially as that -- as those learnings are established, then you might see maybe a reopening -- or maybe not reopening is the right word, an uptick in terms of the adoption, the customer demand. What are you seeing out there in terms of, kind of, getting customer buy-in on that type of philosophy?

Well, I think that the industry -- a software industry now, helps with that, right? When companies like Pega or Salesforce or Microsoft or ServiceNow go out and acquire capabilities and then actually integrate those capabilities into their offerings, then clearly, that's a very strong message that they agree with what I said. So I think that, that's certainly one. They're not acquiring these capabilities to sell them as stand-alone products, almost orthogonal from their core platforms. They're buying them, they're integrating them and they're showing increased value, which is -- so I think that is one obvious thing, is customers will see that, analysts will see that. Everyone will connect the dots. That's one. I would draw the parallel. Think about the way that CRM evolved as a space. It used to be just sales automation. Then there was service automation that was almost something that was completely separate. Then there was marketing automation. Now I think most, if not all companies understand that what you do in service impacts how you market to them. What you do in market impacts how you sell. What you sell has a correlation to how you service. These are not things that are different. There are just different ways to interact with the same consumer. And so they become much more integrated across the life cycle of the customer. When you sell, when you enable, when you renew, when you support, they're all part of a life cycle journey as opposed to like separate things you just sell to a company or separate problems that you're solving. So I think that's a great example of what I'm saying is, I think you're going to move in a direction where these things become really critical parts of how you add value to clients, not just a space that you buy a tool, right? And I think that, that's -- there are other places where you've seen that happen, CRM being a good example.

Perfect. I totally agree. I think there is that convergence there. I think there is that realization that you kind of push something here, it's going to pop out over there, and you got to make sure that everything is interwoven. And maybe shifting gears a little bit here. Look, I think there's definitely been an uptick across software and focusing on profitability. You guys, on your most recent earnings call, also mentioned perhaps dialing back on headcount growth this year. Perhaps if you could just kind of run us through the thinking there and what kind of operational efficiencies you should be looking to extract this year and potentially how that might kind of extend longer term in the form of margin expansion.

So about 5 years ago, we talked about a cloud transition that we were going through, a subscription transition, and how we might exit that subscription transition and how we aspire to be a Rule of 40 company as we exited the transition in kind of our first full year, which our first full year will be 2024. So that has been something we've talked about since 2017. So independent of the shift from growth to value that investors might be making, which, by the way, can equally shift back before we blink. So you can't be running your business in a way that you're constantly trying to guess where investors want value. We always wanted to have this happen. What's accelerated that a little bit is our realization that some of the investments that we made in that new logo acquisition and new markets to accelerate our growth had been less efficient. And in a time when there is economic uncertainty, it may be worse, but let's just say economic uncertainty, it's not the time to make bets on new logos, it's more of a time to invest in your existing opportunity areas where clients will expand, especially given the TAM and our existing clients is so massive, right? It's not something where we could just book the next year. I mean it's decades of spend and growth that we could have just within our core customers. So we were always looking at profitability. This just has been a little bit of a catalyst to say, hey, let's ensure that we're doing the right thing around scaling the organization to make sure we hit our Rule of 40 goals in 2024. And if we didn't do that right now and there was any impact of growth from the economic uncertainty, a strategy of trying to go tackle lots of new logos is probably not going to be the best strategy, at least for the next few years. That just happens to also be an opportune message to the investment community around increased profitability as well. But that wasn't -- our objective was not increased profitability. It was really around where we think we can get the most efficiency and where we can tackle the most growth. And we think that is with clients that either know Pega or obviously want to work with Pega because they're large leaders in their industries.

Got it. Perfect. And then actually you touched on the second point I was going to maybe ask, had a few investors reach out to make sure I did ask. But as you pull back on some of the spend, we should and expect it to impact KPIs like NRR or kind of growing off of that really large robust customer base that you already have?

So I don't think any of the shifts in how we're going to market or we're allocating resources -- well, that in and of itself should not impact NRR. If anything, it should probably help NRR, right? It certainly shouldn't negatively. I think the -- our NRR will probably be a little bit lower just because our ACV is lower for this year because we haven't executed well in the first half of the year in terms of net ACV growth. So that has nothing to do with our focus on work. That's just some of the change management and kind of maybe distractions that we had in the first half of the year that we are well through and working to perform really well in the back half of the year. So I would say that might impact NRR a little bit in 2022. But structurally in our business model, we think NRR has the ability to go up as we actually shift more capacity to our existing logos. And the key difference is we will not get the contribution in 2022 and probably in '23 from new logos that we had originally kind of planned for. And the reason why is it's just not the most efficient vehicle for us at this point in time in the economic cycle.

Got it. That makes sense. Appreciate the color. You guys touched briefly on Launchpad as well. Can you maybe give us a sense for where the interest levels are? What are maybe the initial use cases where this might make sense and how that might evolve?