Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

So we actually -- we allow and support our clients to leverage the Pega Gen AI capabilities like Blueprint, but also our Gen AI kind of accelerators whether on Pega Cloud or not, we actually we have a technology called prem bridge, which basically is the ability for clients to connect their privately managed applications to our Gen AI capabilities. That said, I think Gen AI is just another motivator for clients to move to Pega Cloud. They've been -- when we first started this journey, we were, I would say, more agnostic in terms of saying, you can -- Pega Cloud and then there's also client cloud. And clients were -- for a while, it was kind of 50-50 in terms of the growth of clients on Pega Cloud and the clients on client. If you look over the last 1.5 years, you see that number starting to get up more towards 75%, and I think that number will continue to grow. And in addition to that, you have clients that are selectively deciding to move, to migrate on to Pega Cloud. So I definitely think this will just be another motivation of what -- and to be honest with you, many verticals, many industries have regulatory hurdles to move to cloud. Financial services is one that's been classic. I mean they probably would have moved faster in many use cases if it wasn't for some of the regulatory hurdles. I think those are now not entirely broken down, but I would say in a large way. And I think you're now starting to see countries and regions that traditionally had more concern around cloud actually embracing it. So I definitely think we have -- there's a lot of momentum around cloud in general, Pega Cloud, tremendous momentum. Our sales teams, our cloud partners, et cetera, are all very much behind it. Gen AI is just another one of those motivators.

Yes. And I'd just say, I think our clients have a way better experience running this on the cloud where they're getting outcomes as opposed to having to do the maintenance of the database and the application of patches and other types of things that are, frankly, the reason people move to the cloud is that it's operationally so much more effective.

Yes. Ken, maybe let's talk about macro for a bit. It seems like it's still a topic of discussion among software companies, and we still see kind of a little bit sluggish, maybe not worsening macro environment, but I would love to hear what you're seeing from your discussions with customers around the spending environment.

I'll start and then, Alan, chime in. I would say, look, during -- the pandemic created this artificial kind of spending layer, right, that happened where people were reacting to things. And so growth rates in IT went up for some period. And then they've kind of settled back down a little bit. That's not a Pega comment. That's just in general in the market. What we've seen -- we're selling to the largest companies, the bleeders of their industries, the brands that we all know. And what we've seen is a lot of resiliency in that population. Now that's not to say that they're not under pressure like any other for-profit business. But I think what you've seen is a real resiliency and a real commitment to digitally transform. And quite frankly, still very available budgets to be able to execute that, even given the fact that the industry spend rates have actually come down by a few hundred basis points over the last 2 or 3 years. So I think things have been holding up reasonably well. And I think our clients, we've been very engaged with our clients and Blueprint just gives us another really exciting engagement dimension. But I would say we're holding our own in terms of the software, the technology space and spending. But once again, there are uncertainties. Interest rates are high. There is global conflict. We have an election coming up. There's a lot of reasons to fear stability in the system, but the largest and best-known brands cannot wait because they're the ones everyone is targeting. So we feel like companies like JPMorgan, you have no choice, right? You have to be a leader in technology, and we believe that's why we're so focused on our target, org model and focusing on those exact organizations and why we continue to grow almost exclusively with those organizations. So Alan, I don't know if you have any thoughts to add.

No, I think that's right on target.

Okay. So let's talk about go-to-market for a second. In the last couple of years, you have made some changes. And I'm not sure if that's well understood in the investor community. So you have moved into a targeted account model. You have optimized the sales force a little bit. Maybe talk about those changes and any go-to-market initiatives that you have put in place going into this year?

Well, so I think that we've made all the significant changes that we really feel we needed to make to get the go-to-market into a better shape. And a lot of it now is execution and us getting more effective at following the target org model. We went through a period in which we decided we were going to do a lot of marketing, generate awareness. You guys probably heard all these words from CMOs, generate awareness and build sort of demand pipelines and whatever. Let's just say that didn't work so great for us. And we found that it was much easier to spend money to budget than it was to hit sales to budget. So we decided that in our hearts, we really were in organizations that wanted to do great things for our clients. And part of that is having clients that we've mutually agreed with those customers that we're going to engage. We sometimes make that agreement first and then try to coax coach them into wanting to engage, but really picking targets, staying focused on target organizations. Still have the random things sort of come in over the transom, but really not trying to cultivate the classic demand funnel. And I believe that has both led to better results. Certainly, it's led, from my point of view, to more satisfying outcomes in terms of working with these customers. And I believe that's one of the major reasons you've seen some of the improvements in financial performance that have come along with that change.

And the second change we made to go to market, just to build on that, was the first generation was really focused on the target org model. And by the way, the target org model does not mean no new logos. It means a targeted new logo approach, targeted companies that we know have propensity to buy, that actually fit the scale that we had. The second change that we made was we realized once we kind of went through that first iteration, we realized that our engaged -- client engagement teams were still dispersed across the organization. And so we actually centralize really -- so we wanted to have like kind of the concept of like an account or an org captain that actually worked with all the parts of customer success, of the solution, of the partner organization as opposed to having these orthogonal groups that might -- are well intentioned, but we're actually having different conversations with our clients in a different part of the selling process. That was the second one, and that ended up helping us consolidate some of our management layers. And so those were the 2 pieces we did one, first, which was the target org model, the second, which was kind of refining that target org model, just to help for people that aren't aware of that.

Yes. Ken, I want to talk a little bit on the ACV growth that you have. Q1 was a little bit of a step down and you kind of expected that it will be a slow start to the year. It will be more of a back-end loaded year. Maybe -- so you added something like $18 million in Q1. I think when I look at the guidance, it's almost $120 million that you have to add in Q2, Q3, Q4. Trying to understand, maybe -- help us understand the puts and takes. What gets you there? What could be an upside? What could be a downside there?

So I just -- you're absolutely right with the $18 million. Currency had a little bit of a headwind in Q1. If you adjusted for currency, it probably would have been more like $28 million or $29 million of ACV ad. But we knew that the dimension -- if you look at the linearity of our ACV last year, it was a little bit of an anomaly. And when you think about ACV growth, you're comparing last year to this year. And so if you look across the 4 quarters, last year, we had a very big jump in ACV in Q1. We actually had a slight decline in Q2. We had a flat Q3 and we had a big jump in Q4. If you look at the way that just rolled out and we look at this year, we didn't see that trajectory. We saw more of a level trajectory between the first 3 quarters. So if you just do the math only, what you would see is ACV would drop and then it would come back up. And that's kind of what we had anticipated. And it's not a demand environment thing. It's just, we work with large clients and typically deals that are not insignificant. And so sometimes you have lack of linearity in actually probably many times, you have lack of linearity in the booking flow. So that's really what we saw happening. And so we saw that happening when we guided, and so we signaled that in our guidance, and it happened in Q1. It looks a little suspect because you want to say like, well, why you went from 11% to 9%. Why is it not going to go to 8% and then 7% and then 6%. But the reality is in Q2 and Q3 last year, we've added very little, quite frankly, no ACV, and we know we will this year. So some of it is just the math.

Yes, understood. And in terms of AI kind of contributing to ACV, what are we looking at the time frame? Is that more over the next year?

We've said that our target for this year did not involve any incremental impact from AI. If that happens, that's awesome. We believe it will add pipe.

Yes, I think you mean AI SKUs. I believe they already the success or lack of success of Pega is going to be very, very tied to customers liking and adopting things like Blueprint and the other types of features we've included. But breaking out -- AI out as a set of distinct SKUs, we have a little of that, but it's not meaningful. AI is being driven right into the core of our business, which I think is actually pretty exciting. When I talked about going through another kind of generational change here where we've seen the technology change so much over the years, this is a generational change to the core of the business. Happily, we can do it leveraging what we've already got, which is a nice.

And actually, regardless of whether it impacts Q2, Q3 and Q4 in the numbers, it's critical to the go forward, right? So we need adoption of Blueprint. We need our -- we have our sales teams and our partner teams and clients use Blueprint because it's going to build pipe. It's going to advance. It's going to give us an opportunity to target some very specific new logos as an opportunity. These are all reasons why it's critical for us to have momentum. Now whether or not it generates bookings in Q2 or Q3 is not really the -- the bigger question is, does it actually help us accelerate our growth rate going forward?

Yes. Let me see if anybody in the audience has any questions. No questions? Okay. So on that point, obviously, partners is a big channel for you and you have some very large GSIs built really big practices around Pega. How do you think of that in a Gen AI world, right? Blueprint seems like might encroach into some of the consulting dollars that they do talk about that partnership or the partnership go-to-market, how does that change in the Gen AI model?

So we wanted our customers to be excited about what we were doing with Gen AI and Blueprint. So a full month before we released it publicly, we actually went to all of the major partners, and we had a very deep dive, formal set of discussions with them, and we made it available to them. And we've also said that we're going to allow our partners to be able to submit their own Blueprint. So for example, they can create a blueprint for something if they believe they have the world's best approach to licensing in government or to collections, they can create their own blueprint, which will be owned by an Accenture or a Cognizant or whatever the firm is that does it, and that they'll be able to use with customers but will not be available to everybody else. And candidly, will not be available to Pega. We're not going to be able to see their blueprint so that they can feel that they're really building their own IP. And I'm thrilled to say that I just saw at the end of last week, our first partners submit multiple blueprints. We have to upload them into the SaaS environment, so that they can be available for their use with their customers. So I think we're going to get a lot of partners actually using this as a way to show off what they know, which is exactly, I think, the way we make this positive. I mean the reality is, AI will simplify a lot of the traditional particularly lower-value tasks around building and implementing the system. But there's still a need for that thought leadership in design thinking and creativity. I just think they'll be able to do a lot more for customers for the same amount of money.

If you -- just something to add to that. If you talk to some of the large GSIs and you ask them, one of the biggest costs that they'd love to deflect is the upfront business development cost around showing like kind of an early version of a product. I mean, that -- Blueprint is really solving that problem for them because they're not able to typically charge for that, and that ends up being business development costs that they want companies like Pega or other companies like us to help support. But to be honest with you, they could deflect that. That's just -- that's an amazing accelerator to them being able to show clients a vision early.

Yes. Ken, free cash flow in the model has been an outstanding few quarters now with huge free cash flow growth. Maybe talk about that trajectory. How much -- where do we see leverage from here on out? It seems like S&M is probably still a category that you might get some leverage from, but talk about more -- from here on out, where do we see leverage in the model? Where does that free cash flow margin go?

Sure. So we knew when we exited the cloud transition what we wanted the business model to look like. And I think as we exited it, the business model looks pretty close to what we had hoped it would look like. If you take -- if you account for some onetime items and things that are not kind of systemic in the business are more just episodic. I think when you think about what -- where is the next frontier of opportunity, gross margin in Pega Cloud is certainly one. And that is operational improvements we can make things like leveraging Kubernetes in the cloud and some operating scale. When you look at the leveraging we want to get from things like selling R&D, G&A, we don't want to get those leverage points by actual cost reductions. We want to get those by accelerating our growth rate with a efficient cost structure to do that. And so I think that there's an opportunity to accelerate our growth rate with really, really nice accretion of margins growth rate. We could certainly, just like any other software company, I mean, you can cut your way to whatever cash flow number that you want. You're not -- it's not going to help you in terms of accelerating your growth rate. And we believe target org model, large organizations, we need to be able to be in front of our clients. We need to be able to support our clients. And so that requires a level of attention and investment that might be different than if you're selling a cost solution that someone buys. So we have to be really thoughtful. So we will be very thoughtful about the target org model. We'll be very thoughtful about new orgs. But the reality is we're going to get our operating leverage by being able to expand our growth rate and not have to expand our cost at the same level. And with the exception of one area, which is gross margin to Pega Cloud, which is in the high 70s now, which will be 80%, that has the potential to go above 80%. And quite frankly, our scale, if you think about a $600 million SaaS business with gross margins in the high 70s, that's pretty respectable in terms of other. If we can get above 80% gross margins before $1 billion, which we will, right, which we are certainly on track to do that. I mean, I think we're -- we should be proud of what we've accomplished to get to that point.

Yes, I think I heard expansion of growth rate acceleration a few times, so I like that. And with that -- in that note, let's end it. Thank you so much for the time.

Thank you.

Thank you.