Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Great place to get started. Welcome back, everyone. For those of you that don't know me, my name is Rishi Jaluria. I cover software here at RBC. Delighted to have with me from Pegasystems, CFO, Ken Stillwell. Ken, thanks for being here.

Thanks, Rishi. Good to be here.

All right. Let's start maybe with a little bit of a broad overview for the journalist in the room about Pega. Talk a little bit about what Pega is, what sort of solutions you sell and problems that you solve?

Yes. So there's -- I think there's... there's 2 ways to think about Pega, and they can work individually or kind of in tandem at a client. One way is that if you think about a client that has a large company that uses a number of different solutions to solve disparate problems, think of best-in-breed solutions. I use something for sales automation, I use something for marketing automation. I might have a customer service solution. I might have something that does kind of onboarding. I might have something that does exceptions. Pega can be kind of a process engine or an orchestrator across those disparate solutions, almost stitching together a workflow that would otherwise have a user go into a system, close something out, copy and paste data, go to another system. So Pega can become almost an efficiency play between the systems. Different from that use case, there's also a situation where Pega could actually execute one of those kind of defined processes. For example, in financial institutions, we might do a loan origination application. So not only would we actually do that in the kind of the intake of the loan application, but we would also manage checking the credit score, integrating, sending the underwriting, the communication back and forth to the borrower. So we can actually be the stitching together of a bunch of best-in-breed to do a loan origination. We could actually do the loan origination system itself. So think of us as being anything that executes at scale, processes across multiple steps where there's a lot of human interaction, a lot of value for Pega because we automate and try to take out the human steps and try to build kind of repeatability at scale.

Yes. Yes. Got it. That makes sense. All right. So you talk a lot about digital transformation. And obviously, the one who's been counting the drama on the digital transformation has been Microsoft CEO, right? Satya had said that digital technology is the ultimate tailwind when you've got a world with increasing headwinds. I guess -- do you agree with that statement? And then how do you think about Pega's role in enabling digital transformation?

So I think we first maybe could ground on what digital transformation is to us. Digital transformation is really maybe a catch-all for saying that, where I am and where I want to be, is not aligned, right? So the -- and that could be because you have a lot of legacy applications that are maybe important, but not necessarily modernized and not -- and or could be that your business is evolving and changing and you need to actually evolve and change the technology and how it enables you. And I think companies like Microsoft, and we feel privileged to be in the same discussion with a company like Microsoft. But we're really thinking about how do we play a role in helping our clients use the technology landscape to optimize and expand their business models. And that's not just around dealing with a customer support call that's coming in or dealing with a loan origination or onboarding a participant in a health care plan. It really is around allowing our clients to leverage technology, future-proof that technology in a way that they don't constantly have to have 10,000 software engineers, rewriting code and redesigning applications. So the digital transformation shouldn't be viewed as this onetime thing that then you have to do it again 3 years from now, right? That's just an upgrade. Digital transformation should be a new way of how you think about the interoperability of your applications that allow you to leverage those into the future as opposed to something that becomes episodic. And I think some clients definitely view it as episodic, and there's opportunity for us to help them there. But I think where the real value is to think about leveraging a solution like Pega for many decades to come, even though you don't know what applications you're going to be using over those coming years.

Yes. Got it. Maybe let's talk a little bit about the macro because as you can imagine, that's top of mind throughout the conference. So with kind of all the macro uncertainty, what are you seeing in terms of underlying demand for Pega?

So it's -- sometimes it's hard to connect the economic landscape with your own solution because they can become completed and they're very different things. You might execute well in a tough market, you might execute poorly in a good market. But I would say the one thing that is obvious is that definitely there's more pressure on spend in the enterprise. And where that pressure tends to be seen more often is new projects. When you're thinking about a new project, something that you haven't decided that you're going to do yet, that's where you're going to have the pause. You're going to say, well, do we really have the commitment to do that? Do we want to do it right now? Do we want to wait a year? Where there's not as much pressure is optimizing application environments that have obvious savings because either savings because you don't want to hire back the people that are doing the work or savings because you're paying for maybe older solutions that are much more costly to maintain. Those are things that we -- clients have already committed to. They know they need to do it, they're core to their business. And so they -- those are the types of investments that have more legs than say, a net new. You also have people moving more towards operational and cost efficiency and their spend of technology versus generating leads and trying to build pipe, I think that's obvious. That's what happens when economy is slow. So Pega can help clients on both sides of that. And so because we can help clients on both sides of that and the fundamental core value proposition for us is that we are doing end-to-end workflow automation. What does that mean? It means you need less human beings touching. You have more things done through robotics and AI. You have faster throughput. You have ways to really build scale without actually building scale of headcount. And so I think that even in an environment where times are good, nobody wants to -- they all want to get operating leverage. Every client does. When times are harder, you see not much more push for operating leverage. So we tend to shift more towards the operating efficiency value propositions in tougher times.

Yes, yes. All right. No, that makes sense. So you're just coming up Q3. I think you referred to it as your best quarter of the year so far, in spite of what is probably a worsening macro environment. What's just generally been the feedback that you've been getting from investors post earnings, as well as today at our conference.

I think with -- there's naturally a lot of questions about the economy. I'm sure all of you have questions about the economy as well. That's definitely a hot button topic. With respect to Pega, I think the general feedback has been, it was good to see Pega get back to kind of executing and more of a kind of a normal quarter after we have the distractions of Q2. Q1 was not -- it wasn't a bad quarter. It was probably more of an average start to the year. Q2 was a really tough quarter for us. We didn't execute well. We had a transition in our go-to-market leadership. We had the legal matter. So Q2 was a very distracting quarter. And that distraction really carried into probably the end of July. But then we really executed well since then. And I think most investors were rooting for us, but cautious. And I think seeing the execution in Q3 really, I think, renewed a level of confidence to say, hey, the strategy is working, the business is on good grounding and naturally, as you should be for any technology company, you got to watch the performance of the business because it is not -- it's not as certain a time as it has been in the past few years.

You talked about kind of some of the shift in go-to-market that impacted Q2. Can you expand a little bit on what that is, and how it impacted the business?

Sure. You mean the positive shifts that impacted Q3?

Yes, as well as what made Q2 a little softer?

So Q2, we had our head of go-to-market, Hayden Stafford who we had hired a few years ago, left, we announced -- he actually -- it was a very fast decision, but he left at the beginning of February, we actually announced it a couple of days later, just because we felt like there was no reason not to when we released earnings. So Hayden left, maybe call it beginning of March. So we had a shift to a new head of go-to-market, that's always distracting. But we also had made a commitment at the beginning of the year to move more towards selling to our existing logos. So we call our target org model, which are clients that we've already done business with that have a tremendous amount of incremental annual spend or ACV that we could get from them. So there was a shift, kind of already in process, then you have a change in leadership that causes reassignment of orgs. We actually had a few people in the sales leadership team, leave as a result of a leaving, which is not a big surprise. It happens. So I think that Q2 was already disruptive from that standpoint. And then we actually, on May 9, I believe it was, we had this interesting outcome from a legal matter. And that caused lots of distraction, as you can imagine, for a few months to talk -- to explain it to clients, to calm them down, to say here's what's happening, to make sure they have the facts. And so that just was -- I'm not going to say Q2 was a complete throwaway, but it was definitely a disruptive quarter for us. And I think when we started Q2, we knew that there was probably going to be some change of management, but when we started Q3, we weren't sure what Q3 was going to be because we were kind of right in the middle of what was a busier time with trying to think about what does the economy look like? If you remember the end of June, I think all of you remember that was like probably the height of like what's happening with the Ukraine, Russia, what was happening with the economy. So I think now when you fast forward to November, we got a quarter under our belt, good quarter, not on the backs of any 1 deal. We had the most over $1 million growth in ACV clients that increased over $1 million that we've had for a very long time. So that was great to see. So we're -- so I feel like we've got traction. It's with the right orgs. Over 90% of our bookings in Q3 were with our existing orgs. That's our strategy. So I feel, naturally, you always have, it's Q4, right? We've got 6 weeks left and we probably have 85% to 90% of our quarter to book, which is typical for any software company. So there's a lot of work to do between now and the end of the year. And 2023 is not going to be a walk in the park for any software company. So it's not -- so I think we've got work to do, but I definitely feel like our momentum and getting on the right orgs and communicating with our clients and that relationship that we kind of steered a little bit away from the 2 years prior, right? We are much more focused on new logos.

Yes. Yes. No, that makes a lot of sense. So in the middle of the year, you actually lowered guidance a little bit by about $120 million to $130 million, which you typically don't do. Typically, it's say, we guide once and then go as year goes along. Maybe can you talk about the logic in that guide down and what were the drivers there, as well as alongside that, there is this reduction of $100 million in spending relative to what you initially anticipated. Where are those cost savings or cost-cutting measures coming? And how are you in terms of finding those right now? Are you on track, ahead of schedule or what?

So we had a little bit of a perfect storm on the revenue side, which actually some of it was driven by ACV and revenue. We just felt like we had to reset expectations. We felt like that doesn't typically happen. Big currency headwinds, pretty big shift to Pega Cloud, which is a SaaS solution, which change the revenue model because as you book SaaS solutions, you don't get as much revenue in the current year, you get it more in backlog. And then the third component was because of all the distraction in Q2. Q2 was a very weak quarter on our execution. So -- and we didn't feel like the -- with the economic landscape that we were just going to automatically make up that Q2 gap. So when we looked at that, we thought, that's going to impact our ACV growth. The ACV growth coming down impacts revenue, currency moving against us impacts revenue and the Pega Cloud shift being faster to a higher amount of Pega Cloud, which I think most investors are very happy with, does have a negative short-term impact on revenue. So that was kind of why we decided to calibrate the revenue down and the ACV growth down. As part of that, we decided that we had made a decision kind of earlier in the year that we shouldn't be investing at the same pace in the same areas because we're not going after new logos. We're going to actually -- we're going to focus more on our existing clients. So with that, we had a lot of investment that we had made over the last few years that really unfortunately for the people that were impacted, wasn't aligned with our strategy. So we needed to go and take action, and we felt like the time to do it was actually at the time when you saw this impact of revenue, and we wanted to really mitigate the impact to EPS as much as we could for the year from the revenue. By the way, some of the revenue impact is not really like the cloud mix is not really a performance, and just accounting, but we still felt like why shouldn't we get our go-to-market cost a little bit more in line with where we want them to go. So that -- we've executed that. We've achieved those full year savings, and those will carry into 2023, which is great. We're also looking at ways to get additional leverage with go-to-market, because I think we're still -- even after the what we've kind of settled down on the spend this year, we're still probably in the bottom quartile in terms of go-to-market efficiency. So there's no reason to accept that. And so I think we're renewing our focus. And the connection there, Rishi, is we want to be a Rule of 40 company in 2024. And if we're going to get there at a slightly lower growth rate because we have to deal with the reality of that may be the case, if that happens, -- we need to make more room on the profit side to be able to get there. And by the way, if we end up growing faster and we make room, then we went on both, right? Maybe we give ourselves a higher likelihood to beat Role of 40, so I think it's -- I think we're just -- we're really at kind of a point now where we're exiting the cloud transition. We should see more free cash flow generation. We should be more profitable, and we see a line of sight to getting some of those savings.

Yes. Yes. So let's drill into the Rule of 40, right? So you talked about that exiting 2024. If we think about the drivers on the margin side, I guess, number one, what is that balance of growth and profitability in your mind, as things stand look right now. And more importantly, what are kind of the big levers to get there, right? You've talked about getting cloud gross margins up, you've talked about improving sales efficiency. Maybe a little bit more specific on what are going to be the drivers to get both of those lines up.

So right now, the model that I have in my mind is that we would continue to grow ACV at 15%, and we would shoot for kind of mid-20s profitability. I think there's an opportunity. We're in a big market. We have a ton of available spend with our clients. I don't think this is a kind of a market size or market opportunity. I think it's more just trying to be practical about the fact that it's -- you don't try to shoot for higher growth targets at a time when economic uncertainty is high. So that's just being pragmatic. On the -- how do we get their side, so our Pega gross margins right now are about 70%. As many of you may recall, we want to get those to 75% when we exit the cloud transition, which is essentially 2023 and the beginning of '24, I think we're on pace to be pretty close to that. So I would say maybe check there on the gross margin. Our overall gross margin, which will probably land somewhere in the mid-70s this year, well, as Pega Cloud gross margin goes up, our overall gross margin will start to approach 80. Right? And so we're starting to look more like kind of a more normal gross margin SaaS-type subscription company. When you drop down to the operating expenses, sales and marketing, we should -- if you look -- if you forecast out 2 years, our sales and marketing costs should be probably about where they are now, right? And that -- and in other words, we should continue to stack in ACV and growth, but we probably don't need to in dollars, invest in our go-to-market. Now that doesn't mean we won't hire more salespeople, which just means we shift around the pool of that spend to get that efficiency. If you go to R&D, R&D right now is not -- I don't believe it's out of whack, but I would also say that we have a lot of unique things happening in R&D that give us room to get operating leverage there. We have to build out all the engineering services around the Pega Cloud control plane. We actually have that tremendous amount of modernization activity to help our clients move from what was 5 years ago, most of our clients being on [indiscernible] versions and now most of our clients being on a very recent version. We also had Launchpad that was actually built as part of Phoenix. So we've actually put a lot of engineering investment, but yet our spend in engineering has actually started to come down slightly over time. So I think there's operating leverage there. And I think the -- the last piece of operating leverage that kind of is that mix or should say profitability percentages, the mix of professional services to our subscription business, where our professional services will grow slower than our subscription because we want our partners doing the majority of our services work. The only services work that we want to do are when clients want us to be get engaged, either because it's a lighthouse customer first of kind or it's something more complicated or a really critical client. We don't want to compete with Accenture and Capgemini and Cognizant and all of our partners. We want them to do the work. We got to get -- we do get pulled in at times to our most critical clients. And so that's the reason why we kind of -- now that revenue has been when I started that was more like 33% of our total revenue, now it's down in the high teens. So I think that number will continue to go down as our business grows. If I had to guess, I'd probably say in the next few years will probably be kind of in the 10% to 15% range of our revenue will be professional services.

Yes. I've got a bunch more questions, but I did want to open up to the audience. Anyone have any questions for Ken. All right. I'll jump right back into things. So you mentioned partners, right? And wanting to offload more services on to them. Obviously, you've got a huge GSI ecosystem, anyone who has attended [Indiscernible] world has seen it. You've also been talked in the past about wanting to leverage the partners more on the go-to-market side. Can you maybe expand on some of the efforts there and how that can maybe help you in both ACV growth, as well as just cost efficiency?

Sure. So there's something we're doing. We're not going to do -- going forward with partners and there's something that we are going to really prioritize with partners. We're not going out trying to find net new partners that have no commitment to Pega, no technical skills and asking them to go find opportunities to sell into clients that are not really like mission-critical clients for Pega, meaning mid-market, down market clients that might want to buy a $50,000 or $100,000 solution to Pega. We're not looking for lead generation partners. Someday we may, but that's not what we're doing. We're really focused on the largest system integrators, call it maybe 10 to 20 large organizations that have reasonably good-sized Pega practices that may be geographically or vertically aligned, and we are going hard with them, enablement, funds for business development, joint events, right? Really even proposing, doing proof of concepts together as a team where we jointly fund a client to really get like some level of validation of the value of our joint solution. And that is another area where we did veer a little bit away from that over the past few years as we focused on new logos and down market. I had a conversation with a large -- one of our large system integrators a few -- actually last week. And he asked the question. So with your focus on target organizations, what does that mean for, I'm not going to say the name. What does that mean for us? And I said, well, what that means is, we are going to lean more in with you on our largest organizations because we can't actually grow at an accelerated pace without your help. And his comment to me was, it's about damn time, right? Because we have basically shifted away of focusing on trying to get into new places, new logos, new markets. And quite frankly, that wasn't always with the global system integrators that are saying, "Hey, why don't you just go right here where all your clients are because we're already getting tons of business from them, and we'd like to get more if Pega is actually selling." So we really needed to shift that back. We got a little bit too far over to the other side of focusing on growth in new areas. Not that that's unimportant, we just have to prioritize. And in times of economic uncertainty, it's way harder to sell a new logo than it is to expand with an existing logo. I don't think -- I think anybody at the conference would agree with me on that.

Yes. Maybe I want to drill down a little bit into the competitive landscape. How should we be thinking about the competitive environment? I guess, let's segment it both on to digital process automation side, Appian and UiPath and probably a few more out there. And then on the front office side versus Salesforce and maybe Microsoft.

So when you think about -- I'm going to maybe talk about more of the process orchestration, and maybe the commercialized application suites, right? If you think about the commercial -- if you think about how we compete there, are we going to be the best outbound lead management system, like a HubSpot? No, we are not. That may not even be a good use case for us, right? But -- so the differentiation there is you're not just trying to do a commercial off-the-shelf app, you're actually saying, "I have a sales automation like use case or I have a customer service use case." And it isn't something that I can just plug in like any solution that I buy at Staples, right? Like I actually have to -- there's a deep integration, the workflow, I need to get AI, I might be -- I might actually need to manage kind of all different compliance rules across geographies. We would differentiate heavily against any of the companies you mentioned in that space. If you jump to the other side, talk about process orchestration, most of the people in the BPM space or the low-code space is really a development environment, right? I give you a -- say, here's our platform, do whatever you want with it. Doesn't necessarily have much configuration out of the box, doesn't -- isn't -- the risk is that you can't scale it. You build it once, it takes -- you customize it, it's hard to upgrade, it's hard to manage. It doesn't. And so the differentiation out there is we are really focused on the not just build a low-code environment so you can do kind of maybe long-tail use cases, but be able to do that and be able to have a faster start to a common use case like a digital call center that actually has integrations that are kind of out of the box, right? A configuration that might be 70% done, right? So the differentiation there is a little bit more making it a repeatable consistent upgradable, I used the word future-proof before, right, versus on the more commoditized app kind of side, it's more of the power versus the configuration. So we kind of sit in the middle of being able to be highly configurable, highly powerful and also a level of customization when needed to be able to deal with enterprise companies that have complex technological architectures.

Yes. No, that makes sense. All right. Let's shift to the cloud transition, right? You've emphasized you're almost through it. I think you had said exiting 2023, that's basically the end of the cloud transition. I guess 2 questions there. Number 1, what is kind of the milestones that we should be looking at to say, you're on track, you're ahead of schedule, behind schedule. And number 2, the question is always out there about Pega and this cloud choice element, right, which has continued to be a competitive advantage. How should we be thinking about that cloud choice and how it relates to the cloud transition.

So as we exit the cloud transition, which is -- which you're right, Rishi, would be like kind of the middle of '23 towards the back of '23. The cloud transition, when I say that with that -- what I mean by that is that the AC -- the bookings to the ACV to the RPO to the revenue start to align. They start to make sense, right? Because in a SaaS business, your ACV growth or your ARR growth in one year should translate into your revenue growth for the subsequent year. But when you're going through a cloud transition, moving from perpetual to SaaS, it doesn't make sense, right? Because you have to -- you lose revenue in -- so that's the -- that's what I mean by the cloud, the end of the cloud transition. When things get normal, right, where the business looks predictable in terms of that connected tissue. What that does then is when you -- now you've kind of normalized revenue, that's when you should be able to double down on your operating leverage because you don't have the noise of the cloud transition. Your second question, which was tied to cloud choice. Look, if we could sell every single client on Pega Cloud, I would, and I know you'd like that because I know you're a big fan of Pega Cloud. And I would -- because the bigger Pega Cloud gets the more operating leverage, the more we can get, and we can invest heavier in things that will allow our multi-tenancy and efficiency of Pega Cloud. No doubt. The problem is not every client wants to buy public cloud. And because our clients are -- have complex needs and have varying needs, we've decided that we can't shut them off when they actually want to run it in their own virtual private cloud. So I would say, we'd love to have everything be Pega Cloud. The reality is it's not going to happen. And I would even say, and I'm not saying anything that RBC and other firms don't already know, is there are use cases where using a SaaS provider or a public cloud provider like AWS or Azure or GCP, isn't efficient, right? If you have fixed usage and very predictable usage, you're paying for the flexibility that you don't necessarily need. Where -- when you have the surges and the volatility and you need extra, that's where the real value is. And a lot of use cases do have that. So I think you're still going to have the overwhelming majority of the business look at SaaS. It's not going to be everything. And so we just need to make sure we don't leave any client unserved by our capabilities.

Yes. Got it. Got it. You talked a little bit about consumption there. And one thing that seems to be new messaging is you have this extra consumption like element to the model. Can you walk us through how that works? And what does that do to the potential predictability of the model.

Yes. So that's a great question. So let me clarify that our consumption go-to-market approach doesn't really screw it the model as much as it helps us scale with clients. So what we do is, we actually go into a client, a client might say, "I'm going to buy, let's just let's use cases as a metric". It's a measure of volume. It's typically -- we tend to be more volume pricing sense, not user-based. So they say listen, I got 1 million cases, 1 million loan originations that I'm going to do in a year. But I may surge up to 1.1 million. I may surge up to 1.2 million. There's a vehicle where they can actually either pay us the variable overage or they could take the contractual requirement up, meaning reset the ACV or the ARR commitment with us based on that usage. So think about that model when now you're selling kind of an enterprise level contract where they may be using Pega for 5, 10, 50. We have a client that uses us for 500 applications, right? So now they have this scalable model where they can go deploy a new use case and they can actually use the existing contract. They don't have to go through and try to say, "I'd like to buy this new product. Let me get into negotiate this, what's the pricing and to give me volume purchase discounts," they could just adopt, and then what happens is they will pay us some amount of variable usage or they'll come back to us and say, "Hey, we just went live on this other application." Can we negotiate kind of a commitment to the next tranche because naturally, they'll get better pricing when it's fixed versus if it's variable. So there's not a lot of variable kind of usage that actually hits the revenue model. It's more of a lever point that we allow clients to self-adopt.

Got it. I think that's a great place to jump off. Ken, thank you so much. Thank you, everyone, for being here.

Awesome.