Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

All right. Hello, everyone. Thanks for attending the Wells Fargo TMT Conference. I'm Michael Berg, part of the software team here at Wells Fargo. And today, we have Ken Stillwell, COO and CFO at Pegasystems. Ken, thank you so much for coming. We appreciate the time. So I think we -- mic working? Yes. I think we're going to start off with some of the background. For those who are unfamiliar with the Pega story, maybe you can just give us an overview of what Pega does and cross process management, workflow management, the markets you're after, your target segments, et cetera, et cetera.

So Pega has been around for a while. We focus on segments. One segment, the business process management, sometimes called digital process automation. Think about that space [indiscernible] where you orchestrate work across multiple applications to try to create the connectivity of set of steps that would naturally connect. So that's commonly used in -- it's historically used back office, [ RP ] adjacencies, but it's also used quite a bit in the front office as well, connecting things like marketing campaigns, websites, to interactive customer support, customer service environments. And then the second thing that we do, and I'm kind of just creating 2 buckets is we work with our clients to support marketing and customer service automation. And that is much more of a front office solution that's dealing with customers, either coming into a website and doing kind of contextualize messaging and call to actions and really presenting information to the customer that is relevant. And then on the customer service side, it's typically kind of the desktop call center replacement software. It's really the kind of virtualized customer service software, which actually even connects into voice recognition, voice [ AI ] message kind of social message channel integration, et cetera. So customers that typically buy us are thinking about large-scale amount of customers, large-scale amount of transactions. If you have those 2 dimensions, you're much more likely to be relevant for Pega. If you have not a lot of customers, a higher average selling price, not a lot of interactions, less relevant.

Got it. That makes plenty of sense. Well, you guys have a pretty wide-ranging use cases, products, you name it. In this current macro backdrop, automation, anything that decreased cost seems to be at an increased level of importance right now. Maybe you can walk us through the puts and takes of the macro, both in terms of, "Hey, we incrementally need solutions like Pega to optimize our cost, our spend our people, coupled with; Hey, we have to be more conscious of just our overall spend and budget environment and budget scrutiny." Maybe you can walk us through those pairing dynamics.

Sure. So the 2 kind of areas that I talked about for solutions, they actually fit nicely and to one typically helps you manage, save cost, build automation, build repeatability, take humans out of interactions. And the other -- the second one I talked about is a lot more around building higher lifetime value with your customers, a little bit more kind of selling more and helping clients to sell more. So in an environment like we all kind of believe we're in right now, which is maybe a softer economic environment where clients are going to be focused on how do I do things more efficiently, how do I make sure I'm managing costs, how am I creating risk mitigation against downside? You would typically be on the first one, which is really focused on how can we make our clients' environments operate more seamlessly with less human touch. So not only that you will need less people working in your organization to support your clients, but also you have the dynamic of trying to find and hire those people is becoming harder, right? You can't -- the days of being able to go out and hire 1,000 people into a processing center or a call center, even in less developed markets are really gone. It's very difficult to find that workforce. That's not specifically related to COVID, but it is an outcome of the movement over the last few years. So we're really -- our positioning has always been with a large part of our solutions. We will help you run your business more efficiently and save money. And therefore, whenever times are tougher, you are leaning more into Pega, not less. And so that's always been a key value proposition for us.

Absolutely. I mean it seems like you guys are incrementally at least well positioned in a market like this. With that being said, the other major aspect of your business model right now is your cloud transition, that was started a number of years ago. You're pretty far along at this point, and the cloud PC business are growing nicely over 25% right now. Maybe you can walk us through just a where you are in the progression of that? What does it look like when you convert an on-prem to cloud customer? And then even as like -- it was like when you get new -- to all new cloud and maybe the pricing and ACV type of uplift you get when you make those conversions or just on the net new side as well?

So about 5 years ago, we made a hard pivot to move into a subscription business, primarily leading with Pega Cloud, which is our SaaS offering. Right now, about 70% of our customers -- sorry, 70% of our growth in ARR, ACV is coming from Pega Cloud, which means that clients, both existing clients for existing applications and existing clients for new applications and also net new clients are increasingly looking to Pega Cloud as the solution that they invest in. If you think about the solutions that Pega sold over the years, they were not Pega Cloud because we didn't have Pega Cloud before the last 5 to 7 years. So some of those clients are migrating those workloads over. Many of them will migrate or decide to move to Pega Cloud at a time when they're looking at a big expanded use case around that application. If they're not looking at expanded application, they're getting a lot of value from it, they may decide to continue to run it in the client cloud environment, which is why we give optionality or let clients make the decision. I think the most interesting aspect of our cloud transition, I believe, is not just the momentum around the cloud transition. That's interesting from a financial standpoint. What's most interesting is that almost 2/3 of our clients have experienced Pega Cloud, which tells you that even clients that historically never had Pega Cloud are actually buying new workloads on it. And so that momentum means that we're not completely captive to; a, only new logos buying Pega Cloud or b, having to convert existing workloads over to grow Pega Cloud. So I actually think that we can maintain this cloud choice model and not miss opportunities to sell all new workloads on Pega Cloud, while still kind of strategically helping our clients move to Pega Cloud when they're ready.

Understood. And maybe another helpful pivot for the audience to understand is, what does it look like in either in terms of maybe by vertical or use case where it makes more sense or is it easier to make that transition to the cloud or when they adopt a new use case, is there any specific, whether vertical or types of use cases that make sense? Well, it could be anything from like a compliance reason to just ease of use.

Probably -- maybe I'll answer that question by talking about the situations where it's least likely that they'll move to Pega Cloud because I think Pega Cloud is relevant for most use cases with the exception of a few, heavily regulated use cases, where they may not be able to go into a public cloud. Heavily compliance-driven that might require levels of security that couldn't be deployed in a kind of a public pipe transaction back and forth to a vendor cloud. Governments that might require you to keep data with inside the lines of the -- like GDPR in Europe and some of the emerging requirements. Another example might be an environment where the client has established a virtual private cloud environment has a lot of really fast connected transactions between a number of applications, and they want Pega to be the orchestration engine moving that outside of their firewall into a public cloud may be less -- you might actually have performance right, just because of the -- of dealing with public transportation across public cloud to private. So those are the scenarios where Pega Cloud may not make as much sense. But unless it's one of those type scenarios that is the objection, all else should be Pega Cloud.

Got it. No, that's super helpful in understanding. And I think as we look into 2023 and touching back on the macro, I think it would be useful to maybe dive into how pipeline is building, how it's looking versus historical trends, and you guys have been around for a while. So maybe you can even talk us through how is comparison to '08 and earlier past recessions, and how you're working through this, especially as you are also making the transition to the cloud.

So the -- there's an interesting parallel to 2008 to now and then there's one that's, I think, we're more well positioned. The one where I think we're more well positioned is, in 2008, we sold largely perpetual licenses, which meant in order to not have the business decline, we still had to sell net new activity to our clients. We had to replace that perpetual license. Now we were successful in not having a down revenue year through very tough times for our primary industry, which was financial services because I think we were demonstrating our value to efficiency and automation and saving costs for our clients. What is very similar between 2008 and now is that mission-critical vendors, mission-critical applications, initiatives like digital transformation that are long overdue modernization activities to make sure that companies are competitive from an architecture standpoint, tend to get higher ranking on the list of where the money goes versus things that may be a little bit more testing out new technologies or maybe value that is a little bit more transactional value. I think that -- and that was the case in 2008, and I think that helped us through that time period. When you're running the operations of a business, that's not a lot of options you can have to not do that. And so I think that that's -- given that that's where our heritage has been, I think that has helped us and will help us. And then the last kind of point I would just highlight again is digital transformation is, if not the top ranking thing that clients talk about, it's certainly in the top 3. And given that it's in the top 3 and what we do is squarely in digital transformation, that should help us.

Absolutely. Well, given your positioning in the IT budget hierarchy, I think it would be useful that maybe use that positioning to help us understand maybe some of the other software companies we've talked to a number of the impacts have been sales elongation, impacts to expansion rates, your ACV recently grew 16% year-over-year on a constant currency basis. So it seems like expansion is working well for you. Maybe you can walk us through if there is any impacts to expansion or any impact to sales elongation as you play in the enterprise, given where you sit in the budget hierarchy?

So the places where there's the most pressure, and I'm probably not going to say anything that's dramatically different than what other software vendors are saying because I have heard what some of them have said, and it's my view as well. New logos in a market like this are harder. Are they elongate sales cycles? You have lower win rates. New projects are a little bit more -- have more friction in them unless they're tied to a mission-critical part of the company strategy, and therefore, it would get higher billing in terms of the cost ranking. Expansion with existing clients on applications that are already working and trying to move workloads there are really -- I'm not seeing a lot of headwind to those. Expanding for net new use cases with existing clients because they're thinking about getting off of another system, I would say the friction is kind of in the middle on those, right? Like there's still momentum, but there are some pressure to see if those make the cut. So I would say we have traditionally got most of our bookings from existing logos cross and upsell. And I think that we will just increasingly focus there for the coming few years because, quite frankly, that's a more efficient place for us to sell. It's where we're getting our growth already, and although I love new logos because they do help the future, they're a less efficient sell, and we just have to be thoughtful about that.

Understood. And remind me, what's the mix of revenues from existing expansion or existing customer revenues?

So we typically have between 75% and 80% of our growth comes from existing logos. The rest comes from new logos. Our net retention rate with our clients has been in the 113 to 115 range over the last few years.

Excellent. And then we can move from the front stuff of revenue to margin. I think one place to start advertises to revenues is you've about relative to the rest of software, you have a higher level of professional services. Maybe you can walk us through; a, what's the rationale there; b, how you look at that moving forward and integrating your partner network to either lower that or optimize that; and c, what would you -- how do you view that in the light of gross margins and then flowing down to operating margins?

Sure. So professional services at Pega was -- when we first started as a software company, we were only partially a software company 30 years ago. A lot of the work we did was kind of engineering for higher. If you fast forward to maybe about 5 to 10 years ago, our professional services mix was 30% to 40% of our business, was professional services. If you look now, it's less than 20. And that's largely because most of the work is being pushed to partners. Partners are doing the lion's share. Probably 90-plus percent of the business around Pega is done by partners. We do have some professional services business that we have. We're not trying to compete with our partners, but there are some clients that want Pega to be involved, so what we're really focused on is migrating our professional services business to be a different kind of service. We're looking at recurring advisory services. We're looking at kind of compliance and governance services for our partners. We're looking at enterprise architecture advisory services for our partners. We don't really want to do the configuration work -- the implementation configuration work. And that's what we're moving away from. We're more looking to be the higher-level architectural guidance and advisory for our partners and for our clients. And we feel like that's a niche that we can play, and it's not threatening to the largest SIs, which is where they focus their business. Professional services margins are -- in enterprise software professional services margins typically are not as high as if you looked at an Accenture or someone that does it for a living. So our professional services margins, I think, are very dilutive to our overall margin when we think about being a Rule of 40 company. So therefore, it's also not -- it's not really advantageous for us to double down there.

And I think that's a great segue into my next question is you committed to the Rule of 40 by exiting 2024, rather than 2024, and it seems like you have a number of levers to pull, whether it's offloading more work to partners, optimizing sales and marketing structure. Maybe you can walk us through some of the key levers there, and how you view the -- both the key levers and the mix between top line growth and margin expansion?

Sure. So in 2017, I released our first version of our long-term targets, which showed that we were moving -- we're going to move to a subscription business, try to maintain a growth rate of about 15%, have operating margins to be around 25% and hopefully have a Pega Cloud mix that was approaching 60% to 70%. Through the last 5 years, our view of our growth rate and our margin mix has changed. Our growth rate accelerated, I thought maybe our growth rate could be a little bit faster, and therefore, we would give up on margin to have the higher growth rate. Now we've come full circle, which is interestingly enough, where my view now is ironically exactly what my view was in 2017, which is we're probably more of a 15% grower over the next couple of years with a mid-20s kind of profit margin profile and Pega Cloud 70% of new bookings right now, so probably not that far off of what we had originally thought. And I think that, that model is a model that will take some work to get us from where we are to 2024 because our sales and marketing costs are really out of whack for our growth rate. And that's our biggest area that we've been focused on. If you look at our R&D, maybe it's a little high in percentage, but I think for a company that leads in every Gartner category we're in, I think spending 20% of R&D on -- 20% of revenue on R&D is not irrational. Our G&A expenses are best in class. And if you go to our gross margins, they're really -- they're bogged down a little bit because Pega Cloud has not got to a scale of operating leverage yet. So Pega Cloud is about 70% gross margin. That will be at 75% in a year or so, that will be -- which should be kind of going up toward the 80% number in the next couple of years. And then I think our business really just relies on that sales and marketing efficiency. So we've really got 2 real levers to play other than growth on the cost side, which is make sure our gross margins are expanding through Pega Cloud. I think we have that well in force and make sure our sales and marketing costs really display our focus on Rule of 40. And the way we measure that is how much ACV or ARR growth can you get from $1 of spend of sales and marketing. And the way you optimize that is by making sure that your sales and marketing costs are properly aligned to your strategy, which is our target organizations, which have faster sales cycle, higher win rates and more efficient sales productivity. So that kind of is why we're looking at kind of focusing on our existing logos to a deeper amount because it helps the other pieces of our Rule of 40 strategy.

I mean it sounds like your sales initiatives and your margin initiatives are pretty well aligned even with your top line initiatives. So that works out well, it sounds like moving forward. Maybe that's a good launching point to move on to competitive landscape in broader domain environment. The space you're in is broadly speaking, appears to be converging with a number of other tangential areas, whether it's workforce management, RPI, et cetera. Maybe you can just walk us through the nuances of the competitive landscape right now and just the general increased focus on automation in the current environment as well as digital transformation.

So we have -- I would say we have 2 types of competitors. First off, everybody is talking about digital transformation. It's a buzzword that everyone uses and many companies that use it legitimately can help with the digital transformation journey, a small amount can't. But the majority are, I think, true to the word digital transformation. So you got to really ask yourself, what are you trying to accomplish when you say digital transformation? Are you trying to speed up the work process, the workflow that happens when you do certain activities. Are you trying to get human interaction out? Are you trying to allow self-service to the clients to be able to not only speed that up to make it more efficient, but also speed up the customer experience where you're inserting human beings when needed and not just allowing clients to say, we'll call you back in 38 minutes when we have someone available. Like that model of that's all part of that digital transformation. When you think about the automation and you look at companies like Salesforce and ServiceNow and Adobe and Microsoft and VIVAT, those are all companies that do a similar type of automation that we do, which is enterprise scale really allowing an evolution of the way that your technology is supporting your business. And then there's people that talk about automation that is, I would say, a more tactical automation, things like a copy and paste between screen, things like APIs, things that are ways to integrate systems kind of in sharing data in different -- in fields, et cetera. Those are not unimportant, and they are part of digital transformation, but I would call them more the brute force aspects of what are done. Pega has been, I would say, kind of counted a little bit to come into some of those areas when we did our robotic process automation acquisition about why don't you go into desktop automation and really get into the screen scraping market. And we've consciously decided that, that wasn't a market that we thought was really consistent with the digital, with the end-to-end intelligent automation evolution that our clients are trying to do. So I think -- just -- I want to separate those 2 spaces, and we do not compete in the much more tactical efficiency plays of things like desktop automation, but we have some solutions that can help with that when clients need it. We are much more focused on the enterprise scale, orchestration end-to-end intelligent workflow automation so that we can get inefficiencies out of the transaction flow.

So I think the natural follow-up to that would be, as a customer, there's a lot of like I said, buzzwords, but it's digital transformation automation, RPA, et cetera, et cetera. What do you have to do when you go into these deals? Because it seems like there would be maybe unintended bake-offs versus things like a UI, SaaS or some of even like the workflow -- workforce automation vendors, even like -- maybe like a Smartsheet for example. So how do you navigate that? And is that a headwind of source? Or does it help you in terms of understanding of the broader markets that you play in?

So trying to reconcile what we do versus they do is part of what our teams need to be able to do, right? It's not a difficult thing to show a client. And there are use cases where, quite frankly, it makes more sense to use a Smartsheet than it does to use Pega. And you have to just be -- you have to be recognized that and be transparent about. That's -- we're not a good use case. We're too expensive for that use case. But then -- but to think that those use cases then start to somehow emerge or evolve into managing a loan origination process through a broker to a bank, to a wholesaler, to a mortgage servicing company, it's really a flawed strategy to believe that those transition. So what we really focus on is trying to acknowledge like, this is what that type of automation should be used for. But your problem needs a level of an automation that is something more in tune with what we provide. So I think we've had a lot of success helping our clients recognize where the different tools can be used. And quite frankly, we actually -- everyone of our -- by the way, every client that Pega has, already has Microsoft, Salesforce or Adobe, every single one, right? Many of them have all 3, right? So -- and we're still selling to them because just because you have those solutions, you haven't solved the problem, right? They need to stitch together. And desktop automation tools do not help in that use case so.

Right. Completely makes sense. Well, we are running out of time, believe it or not. So maybe as a parting thought, you could walk us through your long-term thoughts on the road map where you see Pega in 5 or even 10 years from both a product and a financial perspective?

So there's 2 dimensions to that. One is something that I have a high level of confidence in, and there's one that is maybe if things really play to our strategy. Pega will continue to support the largest organizations with their end-to-end automation needs. We will be a vendor that works seamlessly with all of the people that our clients use in their technology environment, by the way, many of which are our competitors, and we are fine with that and so are our competitors, by the way, because they work very well with us. So I think it's a very open environment for that. We will play a critical role in the orchestration of the activity across those applications because nobody else can do it like we can. At the same time, we will also win in some of the more configured use cases like service automation, marketing automation, and we'll win our fair share of those. And we'll become a vendor that is known for enterprise scale consistency, product maturity and really helping in that kind of journey of automation. Then there's the -- if I could dream scenario, right, which is Launchpad. Pega Launchpad, which is taking the capabilities of our enterprise grade Pega platform and putting them in the hands of ISVs and partners and other companies to be able to build their own solutions that would generate revenue on our platform in a multi-tenant environment. And that -- we launched -- sorry, we announced that, that is available in July. We've actually already had our first few partners get engaged with that. We're being very selective on the use cases and the partners, but I think that's a way that the power of Pega could actually get manifested across a much broader market without us having to actually sell it through our -- through a direct distribution channel. And so I think there's -- the base model of Pega is kind of I think, very credible, very durable, and I have a lot of confidence in that. And then there's this Launchpad that really could just be an explosion of Pega's impact on the market. So I'm excited about the opportunity of Launchpad, but also just a tremendous addressable market opportunity we have, even with just our existing clients in the coming years.

Makes all sense in the world. Well, Ken, we're about out of time. So thank you very much. We appreciate it, and look forward to doing this again.

Thank you.