Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

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

Doing great, Joey. Thanks. Thanks for having me.

Great to have you. And great to see you again in person. We have a number of questions, we'll run through, and I'll leave some time at the end if anyone has any questions. But let's just kick it off. Anyone unfamiliar, can you just give a quick overview of Pega and the problems you're helping organizations solve today?

Sure. On Pegasystems, I think the phrase digital transformation is maybe overused. But I would say that when -- what we focus on is, we focus on helping clients automate work or activities typically through disparate channels. So that could be in the back office, connecting something like how to execute a certain transaction or that could be helping -- come more in the front office on helping to onboard a client or helping a client go through a step like a loan origination that might actually touch multiple systems. And so that's our definition of digital transformation. Something that helps to automate workflow typically end-to-end and connecting systems where you don't want to have to do the transactions and the endpoint systems. Now what's -- I think one of the more common use cases in the last few years is this -- is really this movement away from scaling your business by scaling your employees. So a lot of our clients are saying, I want a 2x, 3x, 4x the business or the transactions, but I want to do it with a fraction of the number of people that I have now. So they have to figure out ways to leverage robotics, to do automation, and the workflow to essentially try to do self-service with clients. So those are some examples of how our tool helps to drive efficiency.

That's super helpful. And our classic question. Can you describe the tone of business at Pega and maybe provide some perspective on the overall macro. How is that impacting you guys? And what does demand look like overall as you look into 2023?

Sure. So I'll tell you what we saw in 2022. Now this may be a little bit unique to us because we had some distractions in the early part of the year. But I don't know that it's all that different. In Q2 and Q3 of 2022, we saw a lot of distractions in our go-to-market team. We had a turnover of our Chief Revenue Officer, which actually led to some of that in February. But also, we started to see customers really trying to now in hindsight, really navigating this, what is this conflict in Eastern Europe mean, what about interest rates? There's a lot more unknown, I would say, when you go back to like the May, June, July, August, September kind of time frame. And I think we kind of saw that as maybe something we were experiencing, but we weren't really sure if other companies were experiencing it. When you look -- when you fast forward to Q4 of 2022, Q4 was a pretty normal quarter for us. I mean, I think pipe conversion, pipe build, close rates, engagement with clients, so now that I've actually heard a few of my peers here at the conference and over the last few weeks talk, it sounds like a lot of people are seeing that same kind of thing. So maybe it wasn't completely to what we were experiencing. I think maybe just Q2 and Q3 were a higher peak of uncertainty. Now I will tell you, interest rates are high. A lot of people -- a lot of companies doing layoffs, trying to do cost containment, which kind of does play into our solutions in a way. But I do think there's a higher level of uncertainty as we're in 2023, just about the general economic climate. But I would say Q2, Q3, a little bit weaker, a little bit more concern, I would say, with our client engagement and Q4 but kind of back to normal. Start of the year, I think engagement is high. In the Fortune 500, and I'm generalizing a little bit, but sales cycles tend to be multiple years in many cases for these enterprise solutions. So clients are -- have already thought about what they need. It's not something that they would decide and then buy in the same quarter typically. They might do that to try something out. But many times, they've been thinking about these problems and they're part of a multiyear road map. And so I think that does insulate long-term spending trends with the majority of our customers.

And you guided to ACV growth of about 12%. The midpoint, free cash flow of about $150 million. Can you talk about those underlying assumptions to ACV growth and free cash flow this year?

Sure. So I'll talk about each separately. So on the ACV side, we pivoted pretty hard at the beginning part of 2022 to focus on really expansion of our existing logos, upsell -- so thinking about more of the net retention rate versus our overall growth rate. In the past few years, we've been growing approaching 20% for the last few years of ARR and about 75% to 80% of that came from our existing logos. So we are growing something like 15% to 16% NRR. When we pivoted as part of our sales, our cost adjustment in terms of our go-to-market reduction that we did, both in July and also in December, we were aligning that to focusing on our existing logos. So we do -- so if you take away the significant contribution that we would otherwise get from new logos, take away that cost to drive kind of longer-term efficiency in the go-to-market model, our -- in a 2023 year that would be similar to '20 and '21, we would have been saying 15%, 16%. We took that guide down to more like 12%. And the visibility that we have to that 12%, I think is naturally as you go lower in your growth rate with someone that sells to most -- mostly your existing logos, you don't have -- the lower you go, the less downside you have, of course, right? Because we don't have churn. Our gross retention rates are very high. So I think the 12% was a little bit of a resetting based on selling to existing logos and also some uncertainty, primarily in the first part of 2023. So we just felt like we wanted to derisk that a little. On the free cash flow side, we assumed that, one, our growth rate would drop to 12%. We also assume that the bookings would be more towards the back end of the year. So if bookings were more front-end loaded, that would give us some upside on the free cash flow, because naturally the collections would come earlier in the year. But most of our business does tip toward the back end of the year. So you have this bridging of cash flow that happens between Q4 and Q1, which are typically our 2 highest cash collection quarters.

That's super helpful. And I know Rule of 40 top of mind for Pega. How do you think about your path to becoming a Rule of 40 company? And what would you say are the key drivers of Pega achieving that now that you're almost through the cloud transition?

Sure. So when we first set this out in 2017, the original framework we had was a 15% growth and a 25% free cash flow. And then as we started to grow faster, we said, well, maybe we'll be more look like a 20%-20% -- 20% growth, 20% free cash flow. We even kind of aspired, maybe we can grow faster than that. Maybe we can grow mid-20s, and we would be willing to give up the free cash flow to have that higher growth. I think if I kind of go back and say, what do I think over the next, say, 3 years? I would say we're probably more in that 15%-25%. I think that 15% growth, 25% free cash flow margin. It's put was our growth rate has slowed from our original expectations. It's put more pressure on really resizing some of the go-to-market team that we invested in pretty significantly over the last 3 years. But we said all along. Listen, if we can't get the growth, we're going to make it up on the free cash flow, and we'll adjust our costs. If you go away from go-to-market, you look at the Pega Cloud mix and our Pega Cloud gross margin, we're pretty much right in line with where we said we would be. The thing that we haven't been able to really convert is this increase in go-to-market to drive efficient growth. That has not been something we've been successful with over the last 2 years. And then in the environment we're looking at, I think we'll be much smarter to try to lever on the free cash flow side.

That makes sense. And I do want to touch on Pega gross margin, that reached 70% in Q4. How sustainable do you think that level is? And how do you expect that to trend from here?

So I think it's very sustainable. In fact, 70% is not where we want to land. We're shooting for 75%. And I think we have a shot at getting there in 2023, but we said we'd get there in 2024. And a few years ago, if we go back to, say, 2019, our gross margins for Pega Cloud were in the low 50s. And when we set the goal of 75%, I wouldn't say it was a stretch goal, but I would say it was certainly not a lay-up, either. And I think 75% now is a layup. And I think we're now seeing that we could get closer to 80% as Pega Cloud scales. The way that we get the margin higher is because we aren't selling new logos of smaller Pega Cloud deployments. We're a single tenant for Pega on Pega Infinity. And so naturally there's a fixed cost related to a client as you actually scale your revenue up, you get a lot of accretion in the margin. So if we're selling the clients that are spending more than $1 million on Pega Cloud, and we're continuing to expand with them, the variable gross margin is very high, like approaching 90% on the incremental workloads. And so that's kind of the big lever point we have.

That's very helpful and makes sense. Switching gears just a bit. In January, you announced a reduction of about 4% on the workforce. I'd love to just understand that thinking behind that reduction. And what are some other areas you're looking to reduce costs as a CFO?

So I'm going to go back to July because we originally -- we had a budget to spend a certain amount for 2022, and we took that budget down. So that wasn't a restructuring of sorts, but that was a reduction in spend that we had otherwise planned on. And the reduction there was a combination of primary quota carriers and all of the cost of sales across that. And then what we did was in December, we actually said we're going to focus on -- we're going to keep the primary quota carrier headcount the same, and we're going to take the cost out of the extended selling team. I don't want to say, they're not overlays, some of them were overlays. But much of it was just the cost structure of having partner sellers and vertical specialists and solution specialists and overlay -- and so we tried to -- we took about -- on a run rate basis, close to $75 million to $100 million of cost out of that, but we didn't touch the actual primary quota that we had. So that's what we did in July versus December.

Makes sense. And as we all know, there's been a lot of hype around generative AI and ChatGPT. But how is Pega thinking about integrating generative AI into Pega Infinity. What impact could that potentially have on your customer base? We love your thoughts there.

So there's 2 use cases naturally we'll have to see, because this is -- it's very early stages. But if you're really interested, I would say, come PegaWorld in June because we're going to talk a lot about [indiscernible] we have with ChatGPT and other AI tools. There's 2 use cases that I've seen clients talk to us about and that we're working on. One is, when you're going to write -- either when you're going to configure the product or you're going to write any third-party code that may integrate Pega to another system, you can actually use ChatGPT to actually say, I'm trying to write code to do X, Y and Z with an integration with Oracle. And that -- so that's 1 way. Another way is to use it to actually do the configurations. So if you'd say like, for example, I'd like to determine how to -- what are the best images to be able to show when someone comes from the U.K. with this question -- with this search that comes to a client website, what would you want to show and actually using kind of the body, it's almost using kind of the body of knowledge that's out there to be able to as opposed to us using us, meaning our clients, using data scientists or internal data. I think that there's going to be a ton of use cases that emerge by just having the ability to just like when elastic search became a common way to do search across applications. I think the generative AI is going to be a really great way to do to be able to tap into all of the different applications and use that data. Even if you don't actually use public data, I think you're going to have these data lakes of just client data, so you can actually run these AI tools against as opposed to what right now is kind of almost a fixed set of sample data that we all play around and if you go to the tool now.

Let's talk about RPA a little bit. You're named a leader by Forrester in Robotic Process Automation. What would you say Pega's vision for robotics is? And why do you think your market position jumped so much in the most recent report by Forrester?

So this is an interesting one because when we bought OpenSpan in 2016, we received quite a lot of criticism. And I would say, personally, I did as well with many in the investment community about why we didn't go into desktop RPA. Like, why don't you just go squarely at UiPath and sell $25,000, $50,000, $75,000 screen scraping type RPA use. And when we bought OpenSpan, that wasn't -- not that, that isn't a market, it just wasn't a market for our sales team. It didn't fit with our platform in the way that we wanted to leverage robotics. So what we said was we're going to use robotics as a core way that you can actually automate and drive workflow decisions, routing of work. And I think what you're seeing now with the analyst is that, that has materialized as really taking us up to the right -- to the top and to the right of the quadrants because now clients are doing that at scale. Whereas I think 2 or 3 years ago, the robotics was more focused on the more basic RPA. I think now it's scaled up into that -- the old kind of screen-scraping approach is helpful. It just -- it's not really where you can get the big value. And I think now what you're seeing is robotics within the workflow, and I think that's what -- because just to be clear, our ranking did not actually happen because we're now selling desktop automation. It actually happened because the analysts have understood the importance of robotics within workflow.

Super helpful. How do you feel about sales productivity? Have you seen it improve at all throughout 2022? And how are you thinking about the sales profile that you look for when you hire salespeople?

I'm pretty disappointed with our sales productivity. I think we -- I think some of that we did to ourselves by hiring net new salespeople that more were, I don't want to say, inside sellers, but I would say not enterprise relationship-based sellers, which is where we've really been successful. So I think we probably profiled the wrong types of AEs when we scaled it out, which is on us. I mean we should have been more thoughtful around that decision. So I think that hurts sales productivity. The other thing I think that has not helped sales productivity is this adding specialists of overlays of vertical experts, et cetera. I think it really diminishes the ownership of the core AE. And so I think what we've kind of come back to is if you look at our AE productivity, the AEs, Account Executives that do the best by far, like 4x, 5x productivity are those that have been with Pega more than 24 months and those that actually do not have to rely on other sellers to be able to go and talk about the core message. That doesn't mean that the AEs need to be a subject matter expert in everything that we do. But they have to be able to go and talk about the theme areas that we help with our clients and be able to talk about the use cases and understand it. And that means that you have to have some level of vertical expertise native in the AE. So having an AE, be a vertical expert, cover one or maybe 2 and then actually having them understand the breadth of how we can help them and then bringing in specialists as needed is the model that works for us. And so that's kind of what we're leaning into in terms of our new target organization model strategy.

Got it. And then in terms of verticals that you're selling into, can you talk about Pega Government? What are you seeing from government clients just in terms of engagement and overall demand?

So the government is an interesting space. We've -- it's been -- we have had good momentum in government where it went from less than 5% of our business to kind of more like approaching 10% of our business over the last few years. In the government space, there's a lot of certification requirements that need to happen before you can actually sell and there's a migration to cloud that's happening. So Pega Cloud is now -- it used to be that you couldn't sell cloud into the government. If you go back 5 years ago, it's very difficult to sell. Now I think it's much more accepted, but you have to have things like FedRAMP, which is a certification for the civilian agencies, for commercial-type agencies and then there's something called impact level, IL-4, IL-5, IL-6, you may have heard people talk about that. That's on the defense side. So we actually have FedRAMP. We actually have IL-4. We're working on IL-5. We have FedRAMP model, we're working FedRAMP high. That gives us kind of the entry point. And then our SI ecosystem, I think, is well is mature now. So I think we've had good momentum with the agencies. We now have the certifications that we need and we actually have the distribution channel. So I think -- I'm talking now about U.S. So we really -- if you think about our public sector, we're primarily in 3 markets: Australia, the U.K. and the U.S. We do have clients in France, Germany, but I would say those -- Singapore -- but every country requires certification. So just from a critical mass standpoint, we've tried to stay to the big markets where once you have a certification, you've cleared the bar, the U.S. being more than 50% of our public sector business comes from the U.S.

That's helpful. And you did mention partners. Can you give us an update on Pega Partners? How have you seen those partner relationships evolve? And how much of a driver do you think that could be?

So I think -- once again, this is one of those things that I think we really stubbed our toe over the last few years. When we expanded the partner system, there was 1 thing that we did that I think was really good. There was one thing that we did that was, I don't think, the right decision. The thing that we did that was not the right decision was we went out and tried to acquire new partners that were subscale. And those partners didn't know anything about Pega, didn't have any certification. They were going out, getting new logos that were typically small platform use cases where it's very difficult to scale long sales cycles. So that really is -- if you look at -- if you just take a step back at Pega, that's not how we've actually been successful. What we did really well was we focused on moving more business to our partners. If you look at our professional services revenue, it's the same level as what it was 5, 6 years ago. And the only reason why we do professional services because many of our clients want us to do it. They will not go to a partner or they want us to be involved. So I think that our partner -- we really focused on our largest partner, our large sites, of which there are a lot. I mean we have 5 SIs that have more than 1,000 Pega-certified people. So I think we do have some reasonably sized our size. Our focus now with partners is going to be the largest partners and specialty vertical partners that we can actually help scale up that might actually know a domain or know a specific solution or be in a specific country.

I'll pause there to see if there's any questions from the audience, happy to take any. Yes.

Something on Google Cloud partnership...

Sure. So for those of you that don't know, when we run Pega Cloud, we run it on AWS. We actually entered into a relationship with Google where Google is a client of ours for the Pega platform. It's actually the Alphabet level. So a lot of their portfolio companies are actually using Pega for all of their low-code app factories that they're building. And as part of that relationship, we actually entered into an agreement where we will host Pega clients on Google Cloud. We actually have -- we will have our first live client on Google Cloud this year in 2023. I would say the demand, it's interesting because the demand is -- it's not -- when we sell Pega Cloud, we wouldn't sell it like we wouldn't actually go to a client and market one versus the other because quite frankly, to us, it's the same solution. But some clients have purchasing agreements or commit to consume contracts with one or the other. And so sometimes a client that may be using Google doesn't have any agreement with AWS, and they can get credit for their commit to consume when they buy Pega on GCP. So that was the logic of why we went to GCP. We run on Azure as well. But we don't have a -- we don't run Pega Cloud on Azure largely because Microsoft is a large competitor of ours. But our product works on Azure. So if someone else were to buy client cloud, they can run it on Azure and do either Azure Cloud or Azure BareMetal. So I would say, our view is GCP and AWS gives us enough of the landscape of our clients that we haven't had a problem with someone asking for Microsoft Azure, like they have for GCP. It seems like a lot of clients that really have a negative reaction to AWS seem to be Google shops. And so that was kind of what led us to GCP. So we'll have a handful of clients on GCP probably by Q3.

That's helpful. And then on the competitive landscape, you didn't mention Microsoft. Can you touch on competitive dynamics between Microsoft, Salesforce and ServiceNow. Have you seen any changes on that front?

As boring as this sounds, there hasn't been a lot of change in the competitive landscape in the last -- I mean, I started in 2016. And I can tell you, other than us seeing some -- in some of our clients hearing more about ServiceNow that really, there's not been a tremendous change in the competitive landscape. Our #1 competitor Salesforce followed by a combination of Microsoft and the ERP providers that may sell something like a BPM or digital transformation solution. ServiceNow sounds like a very similar use case to us but they seem to be selling into different buyers in our same clients. But they are one that's, I think, on the rise more. And then if you think about the low-code type traditional BPM, the lower -- I would say, not to disrespect, but I would say the more mid-market -- I'm going to say lower end, the more mid-market or the low-code platforms tend to never really scale into our use cases. So we would see like -- we still see IBM, we see Appian, we see ServiceNow, we see Salesforce.com. But some of the ones, the other providers that are in that space tend to not compete with us as much because we're not selling just a low-code development environment.

Last thing here. Do you think -- do you feel like there's anything misunderstood or feel like anything investors miss or underappreciate about Pega?

We're notwithstanding our lack of sales productivity, which I would tell you is our #1 priority and has been, and we really need to -- it's all hands on deck for improving that. Our expansion and opportunity set within our clients is massive. And I don't -- and I think that there's really an incorrect assumption that we're sold out in our clients. I mean we are so far from sold out in our clients that it's -- but I think that they -- Pega sometimes as a concept of being connected to something legacy because we've been around for 40 years. And I think that there's a natural connection with, oh, if you're legacy, then you must not be able to expand. But if you look at our -- if you look at our largest 5 clients and how much -- and the largest in terms of net ACV growth in the last 5 years, those clients have been around with us since the '80s. And those are the ones that we're actually expanding the most. And their use cases that are not companies that we acquired. I mean they are use cases that are -- they're primarily workflow automation type use cases.

That's a great place to end. Ken, Peter, thank you so much for your time.

Thank you.

Thank you, everyone.