Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Hi, everyone. Welcome to our final day of the conference. Thank you all for being with us this week. As you probably have noticed this year, pretty busy. So thanks again for being here. Ken Stillwell with us from Pegasystems COO and CFO. So Ken, maybe to start the conversation, let's just give folks a little background of the company, origins, kind of what -- where you are now and some of the things you're helping customers to do, just so we can [indiscernible] so the conversation that we'll build from there.

Sure. So we help enterprise clients. And when I say enterprise, typically think of B2C business models where you have lots of transactions, lots of customers, trying to move to digital self-service, use automation in the work -- in the process. We help clients, both in the back office and the front office to automate workflows. Typically, workflows that go across touching multiple systems, so something like a loan origination. We also help clients with things like kind of open close things like a dispute for a credit card provider or a reissuance of a card that's lost or a number that's comprised, but we're helping clients in primarily in the financial services, healthcare, insurance, telecommunications, public sector where there's a lot of constituent management. The platform that we have has kind of different themes of ways that we solve. We help things with like an issuer dispute management. We also are used for things like onboarding a client like a healthcare plan or a participant in a 401(k). We also help with things that might be kind of more around marketing or presenting office, presenting ideas and digital channels. We also have some solutions that look more like kind of a commercial off-the-shelf product like a digital contact center management software, where we actually help call center, customer service reps operate in moving away from like the desktop environment. So we have everything from a low-code platform that you can kind of build what you want all the way up to something that looks like something that you would kind of buy a little bit more as a common problem. And we've been around for -- we are coming up on our 40th anniversary as a company. So we've been a public company since '96, but we were founded in 1983. And interestingly enough, all of those clients that we had in 1983, they're all still clients with us now. The only difference is they spend a lot more, and we do a lot more with them.

That's a good problem to have. Just think about the durability of those customers, and they've been with you. And you mentioned it's all about transforming some of those manual tedious processes and digital transformations of buzzword that's used very, very often. But if you think about those customers that have been enduring for you all over the course of 10-plus years, what do you think it is about those customers, your product, which allows it to be something that is sticky, recurring, how you're helping them to not just solve those problems they have before, but as they're continuing to evolve and grow within their respective ecosystems, how you all continue to address those problems for them?

Sure. So the things -- there's some common traits that we've seen with clients that have invested heavily in Pega and continue to expand. There are clients that tend to use -- these are some of the examples. They tend to use best-in-breed software for point solutions, but those point solutions need to be integrated or stitched together to be able to execute work over. So for example, if you're trying to deal with consumer, you may have a lead generation engine. You might actually have some type of a pipeline management or kind of a nurturing program. You might also have kind of a selling type software application. You might have an onboarding and then a customer success and maybe a customer service. And those might all be different solutions. Someone like Morgan Stanley, you're going to have hundreds of different applications and even different applications depending on the business unit that you have and the specific needs that, that business unit might have and trying to stitch all of those together in an educated way to automate, to get human touch out to use AI when you can to be able to make -- to help people or make decisions for them. Clients love that, the power of Pega to be able to do that orchestration. Another example is things that can't really be purchased in a solution that might be more off the shelf. You might have a problem or more workflow or an activity or a process, there isn't really something that's out there. You need to really construct something. And that thing that you construct might need to change every 90 days, every year as the business evolves. So you want to -- we use the word future proof, right? You want to have an application that you don't have to constantly be rewriting the code, constantly every time something changes. You do an acquisition, you enter a new country, a regulatory rule changes. So because our platform is really a no-code platform, it allows you to configure in the UI and be able to change. So people love -- clients love that ability to anchor in an enterprise create application and then be able to make a change and put it into production the next day. And I think that flexibility is really powerful. And then one additional use case is, many times, Pega becomes kind of the way to verify or handle the compliance of certain standards to a process. If you're thinking about -- like let's use loan origination as an example. You have -- there's -- you're getting inputs both from people applying direct to the bank, but you may also have inputs coming from mortgage brokers and other parties and you may want to be able to then go back and look at a pool and say, did we treat all borrowers the same? Did we actually comply with security and privacy and anti-discriminatory laws and local states and countries? And that's very difficult to do with all the disparate systems because you have to almost check at each point. Pega can become that kind of almost the source of truth that can be leveraged to be able to show compliance. That's another kind of benefit to that orchestration.

Okay. So just kind of double-clicking on that point you mentioned kind of the low-code platform being able to quickly be nimble, be responsive always up because things are constantly changing. If we think about that landscape, just low-code, no-code, there's a lot of names out there. I think maybe what you all are doing is more sophisticated than maybe what some of the others are doing from a complexity standpoint. And it isn't just a simple here's a widget design something that's cute. You're doing the real integrations in the sees the complexity of the workflows, et cetera. So if you were to kind of help just distill the core difference between say, you and some of your other peers that folks may know, kind of how would you characterize that?

So that's a great question. And that is, I would say, both the opportunity, but maybe sometimes become a limiter for us as well. We are very differentiated when you hit scale, when you hit complexity, when you hit variability, dimensionality where you need to be able to handle things at a regional and a global scale and leverage some of the pieces, but there may be slight differences. There are really none of our competitors can manage the level of sophistication that many of these systems are needed. And so when you think about a real powerful enterprise-grade workflow tool, I don't think there's a lot of people that can compete with us there. Negative to that is that you can't -- the benefit of Pega also becomes somewhat of a limiter in terms of scaling. We're not necessarily the best solution to scale the 50,000 companies that may actually have a very commoditized solution. And some of our competitors are more focused on that market. And then there's some that try to do both. And I think the ones -- we've seen our major competitors without going through the list of them are the larger like low-code, no-code workflow type applications, the biggest names in tech are in that space, they tend to have really packaged offerings that they do like a sales automation or marketing automation or a service tool, and they sell those kind of as a piece of the solution. But where they tend to -- where we tend to differentiate against them is when you're trying to pull those together. And so we can compete at that solution at the service automation. I would say our differentiation is maybe more slight there than it is on actually being able to help manage the workflow end to end. That's really where the -- because that's what -- the way they're architected. One of the advantages we have with that is that we operate in a single-tenant environment, which does allow us to do things like real-time integration, things that multi-tenant platforms have a hard time doing because of the tax that it puts on the rest of the tenants.

Okay. And if we just maybe talk about the customer engagement, part of your business, specifically. We were just trying to tease that out a bit here more specifically, how do you see that part of the platform evolving? And maybe if you're thinking about your R&D efforts between the different pieces of your business, are these both equal focuses? Or do you see more opportunity in one side or another?

So it's interesting. So when you think about customer engagement, there's something that we have called Customer Decision Hub, which is basically the brains of our product, it's the AI, right? It's the native AI that we use, and we leverage that a lot more when we're engaging with consumers because you need real-time instantaneous decisions based on information that you may glean from the person coming to a URL. You might know what country they're coming from, might even know who they are, depending on if they're IP address or the cookies that they have signal that. And so the decision engine that we have is actually interesting because there's -- I know later, you have the gentleman from Open AI actually talking in one of your sessions. AI -- if you go back 20 years ago, AI was almost like something that was like a movie like kind of like -- it was like science fiction, right? It was like, oh, yes, AI. It's like that's not really real. AI simply is taking a data set, information, and creating a way to create logic to discern information from the rules of the data set. And we've done that forever. We've done that at least since we did our Chordiant acquisition in 2010. So we've done that for, call it, 25 years. The difference with where we're going with our product now is to allow that integration to other AI tools, right, where we would -- we natively used our Customer Decision Hub, which essentially used all the data that you might provide that and the data models to be able to learn and iterate and be able to improve the quality of the decisioning. Now where we're going is actually allowing that leverage of other AI tools, other data sets, whether that be public or private data sets to do things like it could actually -- you could actually say, write the job a script code to be able to execute a certain activity or it could be, tell me what the best way to process a load is in the Netherlands. And it will provide information. It doesn't mean that information will automatically populate, but it's another tool that you can use as you're designing. Another good example in the customer service area, we used to do something called Next Best Offer, we used to, we do something called Next Best Offer, with our customer service reps. Where if you're on, if you're actually in a panel and you get a call in from a customer, it's taking information in and it's suggesting maybe you should ask them whether if they have -- they're maybe delinquent on a credit card or maybe they have a customer service open ticket. You actually have information to know what the next evolution of that is, the AI will actually tell the customer service person what to say. They'll actually say, say this or say this. Say this, if the customer says -- and then we have voice AI so we can hear what the customer actually says and I would say, now based on what the customer said, the new calculation is this. And that's just -- and that's leveraging things that may actually be outside -- either inside or outside of your data set. So we're really taking that customer engagement, and we're taking it to the next level of AI, which not just to leverage our innate AI, but to leverage other forms of AI.

Actually, that sounds like it's going to do wonders for customers and being able to drive more value within their ecosystems. But maybe just touching on another piece of the business that folks may not be aware of, you all are actually a leader in the Forrester category for RPA. So how is your kind of -- what is your RPA solution and product? Maybe the origins there, which you did slightly different as it compares to some of the other well-known peers that folks are familiar with.

Yes, that's a really interesting story. We bought a company called OpenSpan in 2016. OpenSpan was a leader in RPA. From 2017 to 2020, we've almost exclusively focused on getting that RPA solution native to the Pega platform so that in every workflow and every client, they could leverage robotics. They could leverage it in skipping a step in the workflow or reversing back or auto populating or kicking off some type of a notification or making or reprioritizing to a person in the company like an event or an issue. And we were criticized. I would say, I personally was with the investment community about why don't you just go out and sell desktop RPA? Just go right at UI Path and sell the screen scraping software to everybody and $20,000, $30,000, $40,000, $50,000 transactions and just get a -- and we thought that because we do not believe that is actually where the market was going. We believe that, that was a solution that is necessary, but it is a band aid to the end solution because you want to have systems integrated with each other. You want -- you don't want to constantly have robots grabbing data and copying and pasting, However, that is necessary. So we have a desktop solution. It just wasn't a primary strategy. I think what you're seeing now with the rankings is the recognition of what we said we were going to do is actually the way customers want to use robotics, which is not in a desktop RPA kind of -- there's been screen scraping since the '80s. So that's not something that's new. What really clients want to do is be able to automate inside their applications. And that's where -- I think what you're seeing now is that recognition that that's really catching on in our solution, but it does take a couple of years to kind of manifest that strategy, but I think you're seeing that come through now.

Okay. Maybe just transitioning here a bit. Over the last 5 years, you've all taken an approach to become more cloud-focused, shifting more toward ACV type metrics and to get better visibility into your business, but also kind of to extract more value there. So maybe can you just kind of give us an update on where you see things right now than the transition? And what's going to change operationally, financially and kind of what's your perspective on that going forward?

Sure. So 2017, for those of you that may not be aware, we actually embarked on a transition we've away from a perpetual business model to a subscription model. In 2018, we also pivoted hard to SaaS. When we first started the transition, it was more of an economic model transition that clients really wanted to contract more in the recurring model, gave them more flexibility kind of right in the middle of that, I think there was a pretty big momentum shift up in terms of SaaS, enterprise companies managing on cloud. So in the last 5 years, we went from a business that we had about 3% of our revenue on Pega Cloud and now approaching 50% of our revenue is Pega Cloud. We went from a company that was getting 5% to 7% of our new customer orders were SaaS. Now it's 2/3 of our business. The new business is SaaS. We went from a company that had 70% of our nonprofessional services revenue was perpetual licenses to now it's 2%. So I think we've made the transition. We got through the tough weird accounting that happens there where you go away from revenue upfront to kind of the subscriptions. So I think we've made some good progress there. We also went through the billings trough too because perpetual, you bill upfront, you move to billing over time. 2023 was really -- was always the year that we felt like we would kind of emerge from that and then '24 would kind of be the first kind of normal year, so to speak. Originally -- take that back, originally, we thought we would end at the end of '22 and '23. We're probably about 6 months behind on that transition. So '24 becomes like a relatively normal year. Things are kind of back to free cash flow should be -- the thing that we're actually -- just to touch on the cost side of that, everything I think has went, I would say, as projected on the transition, the cloud move, the cloud gross margin, et cetera. What we did do that we are addressing is that we -- I think like other companies, we probably overinvested or overhired in our go-to-market based on where our growth rate was. And we, unfortunately, did a restructuring in December to take back some of the investment that we have made, and we need to be very thoughtful about future investment. But I think some of that was -- we were kind of maybe in the same boat as a lot of other companies. And I think COVID kind of made it confusing on what the market would really look like when we ended. But that said, the rest of our business model, I would say, is kind of as expected. It's just we've got to get that go-to-market cost as a percentage of revenue in line and then we'll be a Rule of 40 company as we exit 2024.

So maybe just double clicking on that, kind of workforce reduction on the go-to-market side. Given your sales motion, maybe just help us understand the upsell, cross-sell right now and the impact that you'll have within the customer base?

Sure. So the interesting unit economics for Pega is that before we kind of recalibrated to focus on our target organization model, which target organization model is a heavy focus on the Global 1000 and heavy focus on our existing clients to expand to cross-sell, upsell to existing clients. That's kind of our -- that's where -- that's our strategy for -- the end of '22 and '23 going forward. The interesting unit economics is that we had about 75% to 80% of our growth in ACV was coming from existing clients, but 50% of our go-to-market costs were focused on new logos. So you can see the unit economics of how costly new logo dollar growth was. Now new logos are great, if they're the right logos. So if we're actually -- if we're selling -- if we have Verizon and AT&T as a client and we're going to sell to T-Mobile, that's a perfect match. If you have Verizon, AT&T, you're going to sell to like a local telecommunications company that has 400 employees, that's not the right focus, right? That's not a -- and so I think for us, it's really around the right org or enterprise scale. Remember what I said at the beginning, lots of transactions, lots of consumers, enterprise scale, sophistication of use case. That's kind of where our target is. And we think that the changes that we've made, not only in the reduction of the overall selling cost structure, but also the shifting of the primary quota carriers to cover existing logos, a combination of that will have us probably achieve a slightly lesser growth rate than what we had before, but a much more efficient one.

Okay. Got it. So maybe just building on that point, you announced your '22 results in February. ACV was up 16%, which I think was the target you all had put out there the year prior. Pega Cloud revenue is up about 30%. You put a target out for this year. I think it's 12% ACV growth with -- first of all, I think you give free cash flow guidance as well. So maybe just help us understand the underlying assumptions there and kind of what gives you the conviction to start. But that new disclosure, given you have a more robust or more clear understanding of the business, especially in light of macro headwinds, et cetera, that every software enterprise software company is facing.

I think there's a couple of pieces to that. The first piece was we made a commitment in 2017. The 2023 and '24, we were going to be focused on being a Rule of 40 company as we exit the transition. So we felt that the responsible thing to do was to actually start to hold ourselves accountable to that and to focus on free cash flow and to actually set a target and to be serious about that target. And by setting that target, one, it gives us something that we're accountable for. It also is a really important message to our teams, our internal teams around what we expect in terms of margin expansion as we kind of get through. We're not going to be a Rule of 40 company in 2023. We're targeting to be one as we exit 2024. Regardless of whether that happens or not, we will have made significant progress to that goal. And that's kind of -- and so it's important for us to show that free cash flow. We talk about Rule 40 as ACV growth and free cash flow. And we're now at a point where we need to start measuring it. So it just felt logical to actually start to be accountable to that. The second thing is now that we're a recurring business, we have very good visibility on recurring billings and our AR and days sales outstanding doesn't vary that much. So we have a pretty good view of our cost structure, a pretty good view of our billings, which means we should have a pretty good view of our free cash flow. And so we just felt like this is a really important time. Now interestingly enough, it's also a time when all of the investors want to see that too. But to be honest with you, that really was -- that's a little bit of a coincidence because of us exiting the transition at the same time that we're moving more to a value view of companies. And so that just gave us maybe a little bit more of a push to make sure that we did that in 2023. In terms of the last part of your question, which is visibility, look, we have an approaching 100% retention rate. We sell most of our growth is with existing clients. Most of the growth in a year doesn't result in a ton of billings or collections in a year. Our cost structure is relatively predictable or manageable. So I think our visibility to free cash flow is pretty good, right, because we don't have a lot of variables in there.

Okay. That makes sense. And is it worth noting then you guys put out a target to get SaaS like gross margins for Pega Cloud, which you all achieved. Anything that we should think about for kind of steady state margins there for the cloud business going forward, understanding that's going to be a driver towards a lot of the free cash flow growth, especially as you continue to scale that part of the business.

Yes. I think -- I actually -- I think that's a really great story at Pega that we probably don't even talk about. Originally, when we -- originally, if you go back and look at when I did at Investor Day, I think it was at our PegaWorld 2017. I actually pegged gross margin for Pega Cloud at 70%. And then 2 years later, I pegged 75%. I would tell you now, I think we can get closer to 80%. So I actually think like that's not -- I don't think 70% is something to be proud of. Don't get me wrong, but it's subscale SaaS business, too, right? We're talking about a couple of hundred million dollars. If you go back and get a company like ServiceNow and say, what was their gross margins? At $250 million, they weren't 70%. So I think that we're like -- I think it's at least respectable. But we really -- when we move the Pega up to 75%, we were kind of thinking that's not going to be a layup, right? And then now I'm looking at it saying, we'll be -- we're not likely to be there in 2023, could, but we'll be there in '24. So I think now with Kubernetes, with the microservices, how much we're leveraging because our clients, when you get scale, you get some level of accretion on gross margin as the clients spend more. I think -- I don't -- I wouldn't say 80% is my new target, but I would say I think we can beat 75%. And so I think that's exciting. And like I said, that's not a story we really brag about much, but that is a really great thing because that -- our gross margins in Pega Cloud will probably start to exceed our overall blended gross margins in the next couple of years.

Any questions in the audience before I continue? You guys have had good performance. You're hitting the goals that you put out. You're giving more visibility into the future around cash flow, your ability to achieve Rule of 40, but your stock maybe isn't trading where you wanted to trade. So what is it that investors aren't understanding about the story or not appreciating about the story that maybe we can try and dispel here today.

So I think there's two observations that I have and I think one is a completely kind of understandable one, if I was an investor and one I think is not really fair. I'll start with the one that I think is not fair. I think there is -- I think that Pega gets categorized sometimes in the legacy category. And I think we are far from that. And I think that because of that, you look at our growth rate and go, I don't think Pega is really going to be able to grow double digits and keep -- I wonder what the -- and they have a really competitive landscape, they must be oversold in all their clients. And those are all, in my mind, completely unfair false assumptions. But once again, we have to just continue to execute and prove that to be the case. And one simple example is, if you look at our largest client, our largest client doesn't spend $50 million a year with us, just start there and think about the clients that we have and what do they spend with Salesforce? What do they spend with Adobe? What did they spend with Microsoft? What do they spend -- I mean, hundreds of millions of dollars. And we sell in many cases, the same solutions. So to think that we can't -- I'm not saying we can get every client to $50 million. but we should be able to get every client to $10 million to $20 million. I mean, that's like 5x our ACV, if we were able to do that. So that's a tremendous -- do we have a $50 billion -- can we get -- can we become a $50 billion company? I mean I would love to, but can we become a $5 billion? Of course, we can. So I don't think that's an issue at all. The one thing that I think is very fair is we're exiting the transition. We have a little bit -- because of 606, the revenue conversion model is a little bit complicated. We haven't shown that we can generate free cash flow yet. I think there's a healthy skepticism that I think is a little bit of a show-me kind of -- and to be honest with you, I think that's a rational view. I think investors that understand our model and know what we're committed to are going to be very happy that their investors now in 2 years. But I do think there is a reasonable skepticism on, are they committed? Can they do it? Are they going to do -- that's another reason why we put free cash flow out there because we wanted to show our commitment to how important it is.

Okay. Maybe the last question for me, and we'll run out of time here. Plug for you all PegaWorld first time in person in 4 years, I think, Vegas this year. So just recall the date so folks have that. And then maybe I think we're going to have some announcements coming out of that, but maybe there's something you can give us in terms of what's to come in terms of technologies or kind of new verticals, partnerships, et cetera, from Pega, that will be helpful to just......

Yes, PegaWorld first time live just like the great event you're having here, which I know you're oversubscribed, and we would love to be too. So we'll see how that goes, but our last one was 2019. So all through COVID, we did virtual. And I think we did the best we could, but virtuals are in live is live. So I mean there's a huge benefit there. June 11 to June -- it's Sunday, June 11 to June 14. So it's Sunday hit we ended on Wednesday. It's in Las Vegas, it's at the MGM. You can register. You can talk to -- it's an e-mail at Peter Welburn. We actually have an investor registration code as well. It's -- we get -- we'll do an Investor Day there on Monday afternoon. So we'll host somewhere between 25 and 50 investors will be there. You can walk the floors, you can talk to our customers, you can talk to partners. It's a great opportunity to -- I mean, we don't hold you back from anywhere. You can go wherever you want. You can talk to anybody. We're completely transparent with that, the good and the bad. And what you should expect to here, I think what you're going to hear is the powerful relationships that we have with our clients. There's scores of customer testimonial sessions talking about what they've done, transformations that they've done with Pega. There's partner examples. I mean it's just a great example of seeing real life use cases because we do these sessions where clients talk and explain to other clients the value that to help them on that journey. You'll hear a lot about AI. It's -- I mean, not that we're the only person talking about that. By that time, probably everyone will have talked about it, but I think AI is a really important leverage point for us. So you'll hear about that. You also hear about Pega Infinity and how we're helping our clients on that journey to really be the digital transformation platform for our clients. And all the different ways that we're trying to accelerate innovation for them. We're excited.

All right. Thank you for joining us today.

Awesome. Thanks.