Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Great. Good afternoon, everyone. I'm Tom Blakey, the KeyBanc infrastructure, technology and software analyst at KeyBanc. We're happy to have with us the COO and CFO of Pegasystems, Ken Stillwell. Pegasystems, for those of you who don't already know is a low-code platform for AI-powered decisioning and workflow automation. Pegasystems was founded in '83 -- 1983, that is by current CEO and founder, Alan Trefler, at the age of 27 years old and public company since 1996. Most recently, Pegasystems ended 2022 with $1.3 billion, up 9%, led by 28% strong growth in their Pega Cloud SaaS solution, which we'll get into in a little while. So with that, thank you very much, Ken, for coming.

Thanks, Tom.

And Pegasystems -- I just would like to start with a generic overview of the platform and instead of going too long about it, I think it's best given like you have some great Tier 1 examples in terms of where the platform is being used to kind of help people understand what a software solution and platform like Pegasystems can do in terms of helping bring automation to workflows, as just an example?

Sure. So I think one of the -- probably one of the best examples, I'll give 2 examples that are very different use cases. One example is you have a large organization that has a common fragmented intellectual information technology stack. So they might have -- they might buy one solution for lead gen, one for pipe management, one for onboarding a customer, one for customer service. And that's pretty natural because they want to buy best-in-breed for each of the different solution areas. Additionally, they may have divisions or business units, which may use some common technology or may use different technology depending on how much they may kind of interact or how much they may actually have their own technology decision like their own CTO or their own CIO and be able to make that decision. So when you have a situation like that where you have a big company, complicated technology stack, which is in lots of customers and lots of transactions, which is pretty much any company in the Globe 1000. Pega can play an orchestration role. Essentially that end-to-end work automation is helping certain transactions that are not like open ticket, close ticket. There are things that tend to progress through different steps and stages through the -- that could be onboarding, it could be managing, an underwriting of a policy, it could be onboarding or could be a loan origination, things like that, that might happen in different industries. So that's an example where Pega would be kind of that the orchestrated workflow where we would manage in -- and we have a kind of a container technology, we call it a case, which is basically a container to manage the work and then when the execution is done, whether that's a minute a day, a week, a month, a year, we would then write back to the systems of record any information and essentially keep track of a lot of our clients have to do audits and have compliance requirements around their process to make sure that they followed certain ISO standards. Another completely different use case would be we would -- when clients are using a desktop customer service type legacy application and they go to people working remote and they want to actually use self-service with consumers, they might deploy a customer service application that is a little bit more of a kind of virtual desktop, right? Something that clients can access from anywhere. You can actually configure and think of kind of the UI would essentially be a dashboard of all of the different places where customer data might actually be held. So in that situation, Pega is not really the orchestration engine. Pega may actually be the UI that is used by the client and it's pulling information from all the other systems. And it might do things like automate certain steps. It might actually use our AI engine to be able to drive decisions and next best offers that voice AI to actually help to translate what might be happening and give and even with the new generative AI, be able to serve up a suggestion like we suggest that you say this to the client. It doesn't mean you can make it so that in a digital channel, it might actually on a phone, it might text that answer back or might just serve that answer up for the customer service represented to make a decision whether they actually want to say it in their own words. So those are 2 different -- very different use cases where our platform helps clients to digitally transform.

I think it was important to make sure we kind of flush that out too because Pega from a conception perspective, can do a lot, and it has a very broad applicability. So that's very helpful, Ken. Similarly, in terms of the Pega story, you've been within a couple of transitions the last 5 years. One perpetual to subscription transition, which a lot of software companies have been under and also with a SaaS solution that you've offered the Pega Cloud, which has been growing very dynamically of late. Could you just maybe bring us up to speed with a little bit of history in terms of why, especially with the Pega Cloud, these decisions were made and where we are in terms of maybe wrapping up some of these transitions?

Sure. So I wouldn't -- I don't -- I think it would be a mischaracterization to say that when I started at Pega, it was to drive the transition, the transformation that we went through. But I would say when I started at Pega, it was pretty obvious that we had a transformation in front of us. We were perpetual-based. We sold to a smaller number of enterprise organizations with a lot of -- with very high or reasonably high NRR. And when we engaged with those clients, they were very long-term relationship. So a perpetual model doesn't make a lot of sense in that model from the Pega standpoint. It also became an impediment for our clients when they want to expand. But they had to go through a contracting exercise continually. And naturally, if you're in today's world, if you want to consumption basis, flexibility and usage, being able to look at other use cases and leverage the technology with business users, you need to think about the contracting model as well as the technology. So the first step in that was to really kind of finish perpetual license model with Pega. We were already kind of over the years, had transitioned some of our relationships. But with that big push in 2017, we moved -- we said we're not -- we're basically -- we're way behind anyway. So we said we're not going to sell perpetual licenses anymore. And we made this shift to subscription. Subscription to us at that time didn't mean SaaS. It didn't mean cloud. It just meant recurring relationship that was allowed clients an easier ability to be able to scale their usage, be able to -- that relationship that was an evergreen relationship. What happened was in 2017 and into the beginning of 2018, there just became a noticeable shift towards cloud in our clients. Some -- if you were to talk to Salesforce, they'd probably say that was 2009. But for us, we kind of saw it in the 2016, '17, '18, '19, where the government started to push for cloud first. Clients like I can remember, a large competitor of yours or probably the largest competitor of yours, where the CEO sat on stage in 2017 and said, we will never go to the cloud. And then in '18, he said, maybe we'll be 50-50. And then in '20, he said everything is going to be on cloud. So I think you could see just as an example, how quick the industry moved. So in 2018, we said, listen, we -- our technology must -- we must manage our technology in a SaaS environment because clients are going to force it. So right in the middle of a transition to subscription, we added on top of that the complexity of saying let's move to SaaS. Fast forward to now, we are done with that transition. I mean, I'm going to say done because we're in the last kind of couple of quarters. So let's just call it done. And so when we think about what does the business look like on the other side of that, we had originally said when we're done with the subscription transition, the 12 months following the completion of that, we will measure ourselves under a Rule of 40 standard. We're growing at 20%, we want to get 20% free cash flow margin. If our growth is 15%, we want 25%. And so we made a strategic bet a couple of years ago that is to accelerate our growth by accelerating our go-to-market spend. And admittedly, I think we struggled a little bit of that, mostly because of the product market fit of going down market with an enterprise platform. So I think we've kind of recognized that misstep, and we've really kind of leaned hard into the Global 1000, Global 2000 existing organizations, companies that really have the propensity to spend that our solution is a perfect fit to be able to solve the specific challenges of enterprise. And so where we land now is we're hitting the transition to SaaS actually has played out almost exactly as we had thought. Gross margins are 70%. They're going on their way to 75%. I think we have some real sight to see closer to 80% on our gross margins on SaaS in the next couple of years. We've got 2/3 of our bookings or thereabouts is Pega Cloud is SaaS versus 1/3, which is the client manages that subscription license in their own cloud. And what we're really unwinding now is this excessive amount of sales and marketing investment that we made. I mean I think you could probably put us in the same camp as others to say we probably overhired given what we saw during COVID. I think COVID -- there was a lot of digital transformation initiatives, but we probably -- maybe our eyes were too big for our stomach, so to speak in terms of hiring the where -- that's the piece that we need to kind of correct.

Yes, we'll get to that, and I just want to preface that way. You're not in the worst camp there. There's a lot of people that are laying off 10%, 20%, 30% of the staff. So you're doing low single digits. Before we get to that, you mentioned a lot of things there, strong NRR focusing on the G1K, not even the G2K, strong in the federal vertical. The question is around this next kind of phase in this weak macro or softer macro, people focusing on TCO versus more digital transformation like they have been in the last couple of years. Talk us through like in the notion of -- or in the context of visibility when you look out to your '23 guide, in this kind of unique position, quite frankly, that you have in terms of focusing on your existing customers, strong NRR, just -- and what are the sales -- what are the motions that are pushing demand today in terms of TCO and digital transformation?

So I'll maybe start by characterizing that if the economy was much, much worse than we think it is right now, which meant that there was literally little-to-no incremental investment other than existing spend, I think every company would very smart to focus on their existing clients and making sure that they don't have any churn and that they're solving and helping their clients be successful with the investments that they've already made. In some cases, that they haven't fully realized the value. So start there. Now let's go to a, well, it's not a zero cost increase, but it's a little bit more -- a little bit more scrutinizing spend and trying to pick projects, what would be the projects that both G1000 companies would pick? They pick ones that are going to help them optimize their cost. They don't want to have to be reliant on hiring a bunch of people back when -- they want to get consumers to a great self-service experience, not just self-service, but one that they can actually solve their problems. They want to get rid of legacy systems and inefficiency and homegrown. So if you think about all those, that's -- those are all digital transformation initiatives that help the bottom line. Pega has been -- we've been through -- because we were founded in 1983 and still have the same CEO and we've seen a lot of tough markets. A lot of tech companies haven't actually seen a tough market yet. We've seen them and we've leaned in to the cost savings efficiency play during those tough times. And it's worked for us. I mean we grew in 2008, 2009 with over 50% of our customers in the financial services industry. And so -- and we still grew through that time period. How do we do that? We help them engineer a change in their technology strategy to get drive efficiency. I don't think today's environment is anywhere near that, but it still has some of the same traits, which is companies, value is return on investment, value profitability, durability, they're critical in tech but our clients are thinking about those at an increased pace as well. So I think that we can play into that value proposition really well.

It shows the flexibility of the platform. It could be digital, revenue generating or it can be digital TCO?

Absolutely.

And that's a great data point on the growing the BFSI segment during The Great Recession. So you mentioned very quickly just as a follow-up there on pricing. What kind of pricing was embedded in the guidance? Or in general, what kind of pricing, let's just say this way, what kind of pricing do you generally take or typically take annually?

Do you -- you're just talking about price escalators like CPI? Yes. So like-for-like solutions, we'll get -- we typically have kind of a CPI-type escalator in our contracts. We don't have the opportunity at all of our contracts to execute that increase every year. Sometimes it's at renewal, and it may be a multiyear adjustment or sometimes it is every year. So -- but we've been seeing kind of that number being in some cases, in like some parts of the world, it's kind of closer to 10%. In some parts, it's 3% or 4%. It kind of -- but there's some number, just if you average all that out, it's probably in the 5% range. We don't get that across every single customer, but when we get it, it's been kind of in the mid-single digits.

Okay. You mentioned earlier when you were giving the preamble in terms of the overview of Pega about the subscription, transition and especially obviously Pega Cloud, maybe encouraging more usage, that flexibility being able to consume more Pega as opposed to having these contractual hang-ups and hiccups and whatnot. Can you just maybe walk through any metrics that you can share as we start kind of [indiscernible]? It might be too premature, but what you're seeing in terms of maybe a possible uptick contract value from a kind of a net retention rate?

So we -- so I will kind of tell you what we're seeing and how we see it playing out. I think the metric side of it, I think, is a little early in terms of having credible metrics other than what we see that kind of anecdotally. But if you look at the model for AWS, GCP, Azure, Snowflake, I mean, they have consumption-based contracts, but they're not like consumption-based like it's zero, it's 1, it's 10. You get better economic pricing based on longer-term commitments and the annual spend, but you have the variability to be able to surge and you can get the -- so if you spend more, you're going to get increasing discounts on. If you spend less, your discounts start to go away. The more you commit to an annual usage or a multiyear, the better economics you get. The model that we're using is not unique. It's not innovative. Other companies are doing it all the time. And if you think about our relationship with AWS as a perfect example, you get -- there's 3 types of discounts you get. You get one discount for the total contract value commitment. You get another discount for the actual spend. And you get another discount, if you actually pick efficiency spend models and locations that match where they need to actually get efficiency. So like you're both saving in that. If you think about that, we're not dissimilar to that model. But now in terms of the new contracting model, the way we're thinking about this is instead of going out and signing a 5-year contract with the client, where there's a fixed amount of usage at a fixed price or a price that may escalate CPI each year, we went out to our clients and said, let's not make it that rigid. How about we have a directional commitment of an amount that you tend to invest over multiple years, and you have a peg for how much you might actually spend in a year. And then you have complete flexibility to deploy the solution anywhere you want. And we will not measure your usage until your application is in production 90 days, 6 months, whatever that number is. So what you're giving them is you're giving them certainty to go start an application, get it into production, get it the value and not have to immediately start measuring and paying. It doesn't cost us much. Sometimes it doesn't cost us anything, right, to be able to let them do that, but what you're doing is you're driving the client to self-adoption. And now the reason why we do that is because we know that once clients have the ability to test it out and use it, that they will adopt more. Now there are some things that we ask for from the client. For instance, we want to -- we believe you need a center of excellence for Pega, which means you need skilled resources inside your organization. We want an enterprise architect to be [indiscernible] organization to help you think about the right types of projects and how you roll that out. And those -- we've had that relationship now with a handful of our very largest customers, they love it. They love it because they don't have to constantly be in a contracting mode, and they actually have some level of certainty, when they end the year, they're not just going to wake up one month and say, oh, I just got a bill for $13 million for overage, which is the real negative that happened early on with AWS, right? Everybody would [indiscernible] the same thing that's happening with Snowflake. They've talked about it. People get bills and then you have to like they say, what happened, I need to stop using you. You don't want to have that scenario. You want to have a level of predictability. And that's really what we're trying to work with that model. But what the downside of that is, is that your things like your remaining performance obligation might actually be lower over time because you're not in the business of just trying to book a lot of backlog commitments. You're trying to build a business that scales, that grows faster, the clients self-adopt. So you have to think about that trade-off and also the pricing economics you have to think about.

Very helpful. And by the way, just a point of clarification. That's not just subscription, that to Pega Cloud as well?

That's anything subscription. Yes. Yes. Anything where there's a subscription arrangement, we're moving with all of our clients to have that flexible scaling.

And as an adjunct to that, and maybe even an expansion of that, you developed a new product called Launchpad recently, just in the notion for everybody. It's even more so pushing Pega towards this platform status. Just maybe walk us through what that product is and how that could expand many more applications being built on your platform?

Sure. So Launchpad -- so we've been trying to really kind of downplay Launchpad internally because we don't want our sales team -- no. No, it's okay because it's kind of taken a life of its own. We've tried to downplay Launchpad a little bit because we don't want our sales teams to be -- to lack focus of Pega Infinity, which is the enterprise platform that we -- that's where we make all of our money and that's where all of our enterprise clients are going to be purchasing. That said, what we found out with Launchpad is that there is a massive market, but a market that wouldn't be addressable with our Infinity architecture, because our Infinity architecture is single tenant, it is enterprise scale. It's not built for multi-tenants. It's not built for ISVs or software providers to build on top of it. It doesn't -- it has a fixed commitment of capacity. It's a little bit more like an enterprise model than it is like a traditional commercial off-the-shelf multi-tenant application. But what we realized is that nobody else has what Pega has. So the Launchpad was our way to kind of democratize all the capabilities of robotics, of AI, the case structure, the low-code platform, but be able to allow clients to be able to use that, that were subscale. And they will use that on more common use cases through managed service providers. So we will not sell directly to them. We will basically license our platform [indiscernible] provider that will then craft certain use cases and sell those to multiple. An example -- a very simple example is, let's say that you had a medical device manufacturer that sold equipment to hospitals. And the medical device manufacturer might actually buy Pega from an enterprise perspective, but they might want to build some type of a managed service to manage the maintenance on their equipment, the consumables for their equipment, but they would have to go and build that application on their own and they'd have to try to outsource it to somebody else. What we will do is put the power of Pega's platform in front of them through Launchpad, we will work with them, maybe their own team, maybe a system integrator to build that application and then license a subscription to all the hospitals to be able to manage all of their equipment, and that's kind of a subscription fee for service. So a lot of companies that sell kind of fixed -- fixed transactions want to move to recurring. This is a way for them to transition part of their business into a subscription model. The automakers are another good example.

It just seems like a very unique channel to help Pega become more of a platform. Kind of running up on time. Is there any questions from the audience? I have more -- just maybe one final one, Ken. You talked about the Rule of 40, exiting 2024. They've been very prudent in terms of OpEx, and you had a very most recent quarter in that regard. You also decided to add a new metric to the guidance in '23 with free cash flow. I just wanted a couple of questions there. Why -- why is '23 the right year to now start giving us free cash flow guidance? And how confident that you and the firm's ability to deliver on that $150 million in free cash flow guide you gave for '23? And there were some adjustments there about investment in property and equipment and interest expense [indiscernible] just thirdly, why are these adjustments important and just share some thinking around that.

So we've heard that the market cares about free cash flow. So we -- no, I think when we had talked about Rule of 40 in 2017, we kind of talked about the -- when it's relevant will be a Rule of 40 company. Well, it's relevant now, like we're done with the subscription, it's time. And we never produced a free cash flow measure. I mean, you could easily get it because you just look at our financials, but it was not a measure that we talked about that we measured ourselves to and that we talked internally to employees. So the Rule 40 mantra is everywhere inside Pega because it's important because we need everybody in the company to appreciate how important being a well-run business is. So we wanted to first, we wanted to tell people externally that, that mattered to us. We wanted to hold ourselves accountable to that free cash flow measure because it is a really important measure. It is -- other than ACV, it is the second most important measure, naturally, you can have free cash flow without the ACV. On the adjustments, what we did was we basically said, let's take our operating cash flow, let's subtract our property, plant and equipment in our CapEx and then there may be other things that are not recurring things in the business like certain legal expenses, maybe acquisition expenses, other things that we felt like -- and by the way, we're very transparent there. If an investor says, I don't want to add that back, they could very easily just take it out and model us without it. But for us, we felt like there are things that are -- I don't want to say out of our control, but I would say not really part of the business fundamentals. And so we don't expect like a restructuring charge, if we did the lay things like that. So that's -- those are the types of things that we kind of added back.

Including interest expense. Is there any signaling you're there with your -- with regard to [indiscernible].

Yes, that's a great point. The reason why we looked at -- we looked at kind of unlevered free cash flows. We don't believe that a significant debt balance is part of our operating model. And so we don't have a lot of interest expense. It's only about $5 million or $6 million, but we did take that out.

I was trying to highlight you have a great balance sheet. Very big platform with expanding use cases and cash flow. Thank you very much, Ken, and I appreciate your time.

Thanks, Tom.

Thank you.