Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

Thanks for joining us. I'm Rishi Jaluria. I cover software here at RBC. I think I've actually covered your stock for probably a decade now, predating you, Ken, believe it or not.

Yes.

So I have Ken Stillwell, who's the CFO and COO of Pega. What was it like 4 years ago, you got the promotion to your duty?

Yes. Good memory, yes.

So thanks so much for coming. Maybe a little bit of a brief overview of what Pega is and some of the changes that you've overseen in the business over the past several years?

Yes. So I'll be brief on the Pega side. I mean think of -- there's lots of applications that need to be digitally transformed. Most of those applications have some level of workflow, which means they're executing certain amounts, certain tasks across steps integrating with systems and Pega is a workflow company. We have a workflow engine. So much of our business is around helping clients with either use cases or existing ones that they want to digitally transform and getting them to a more modern environment. When I started in 2016, we were like a 2/3 perpetual business, and the 1/3 was term license. We didn't really have -- we had a little bit of cloud, a little bit of SaaS, but not much. And the previous places that I had been at, the one right before, that was Dynatrace, where we had -- we went through -- one of my first initiatives was we're not selling perpetual licenses anymore. We have 100% retention. The systems last forever. These are large organizations. We really need to continue to stream innovation to them, and that's more of a recurring subscription model. So that was kind of the first step. In the -- at the time, I wasn't really sure if there was going to be cloud adoption in our space, right? A lot of the use cases that we have, have more of a regulatory spin on them. Maybe it's not regulatory, but it's certainly deep compliance or quality. And at that time, I would say some verticals, even the government was still kind of a little bit timid around moving to the cloud in a big way. But we were going to move to subscription. I would say it was probably a year into that and things just started to change rapidly. And so we pivoted and said, we're not just going to be a subscription [ business in a ] bigger way. So we hired some talent from the outside that had run cloud company like central to that. We actually put actually underneath me at times so that I could help to [indiscernible] as we move to cloud, including engineering, cloud operations teams, et cetera. That's what led to the expanded role 4 years ago. But we really -- where we are now, if you fast forward to now, we're 80% or something like that of our growth is cloud. We are going to be close to 50% of our ARR, we call ACV, annual contract value. But of our ARR, ACV is cloud and cloud means SaaS. And almost all of our business is recurring. I mean there's just a tiny amount. I mean, we might do a couple of million dollars a year on perpetual license. It's almost -- I just say 100% just because it's so small. So plan now is to help our clients that haven't moved to the cloud move and really push all new use cases to the cloud. So our goal would be in, say, 3 years that, that 50% number of cloud is closer to 80%. So that's our objective.

Yes. So as you can imagine, most of our dollar is probably going to be on the cloud transition and Blueprint [indiscernible] your conversations.

Yes, and cash flow.

And cash flow. Yes, we'll definitely talk a lot about that. Maybe let's start on the cloud side. So what incentives are there for customers to be on Pega Cloud? What can they do with Pega Cloud that they can't do with client cloud? And from your own perspective, how that ACV translate?

Sure. So the simplest way to think about cloud versus noncloud is that we take a significant amount of work that the client needs to do to be able to stay modern with the application, and we take that. We own that. We do that for them. An example is if we actually release a new capability, the client, if they're not on Pega Cloud, go through an upgrade cycle. They need to plan that upgrade. They need to time it out. They need to do testing. They need to test the new version. And that typically -- most companies that are not on cloud, enterprise companies not on cloud typically are a couple of years behind on that upgrade cycle. So if you release some new innovation, they may not see it for 2 or 3 years, right, sometimes longer. So that's a big value shift, right? The clients can get access like within months, right, to the latest technology. And I'm just saying months if it's slow, right? The second one is the elasticity, the reliability, the security of us managing the cloud on someone like AWS or GCP far exceeds the efficiency that, that client can do trying to manage that environment themselves. Now the one exception to that would be if their application never touch the public at all, meaning it was inside a firewall inside their company. Maybe 5% of applications actually meet that criteria where they never actually touch a URL. But they're going out to the public, there's bad actors that are going to come and try to hack that system, right? And I'd much rather put my bet that AWS or GCP is going to actually [ hear ] those environments than I would each individual customer doing it on their own. So that's a second value prop. The third actually put new workloads when they want to push innovation, that happens faster on Pega Cloud. If you think about if I'm going to go and if I'm a company that wants to go and start a new application, and I'm going to do it on my own. I've got to go out and talk to my IT group and get servers. I've got to get someone to deploy it. I've got to figure out where, what are the operating systems. I've got to get people to implement that. With Pega Cloud, we can spin up in 5 minutes, right? In fact, that was [indiscernible]. We don't even do anything. Like a client can actually initiate capacity. It will know, and it will spin up an instance for them. So there's just a speed and pace of innovation to the best capabilities that we offer at Pega that is just very different than if a cloud does.

Yes. That makes a lot of sense. Take you to the numbers. So we saw an accelerate to, I think, 26%, [ 18% ] overall. Should we be thinking about the growth of both of these going forward, especially because you're tracking ahead of your own 2024 guide?

So I think the one caution that I would have is Q4s can have a higher percentage of noncloud. It tend to be the end of the year. There's a cycle of budgeting that's a little unique at the end of a calendar year for a lot of our clients. So sometimes, that number -- and I'm really focusing on Pega Cloud growth, right? Because if there's a higher percentage of non-Pega Cloud, that growth rate could move around a little bit. That said, I think our Pega Cloud growth rate if we're going to achieve our 75% to 80% of Pega Cloud in 3 years, that growth rate has got to stay above 20%, right? So you got to stay above 20% pretty much going forward. So I think that's kind of a number that we should watch, right? The second part of that is the overall ACV. Whether they buy Pega Cloud or they manage it themselves, we call that client cloud, they're managing it themselves. That total number right now, as you mentioned, constant currency is 14%. That's about 300 basis points above our guide for the year. And I would say just being very objective, we did have a little bit of an easier compare in Q2 and Q3 compared to last year. So I just think just being very honest, that does help a little bit on the optics of that. That said, if you look at the growth of dollars, ACV growth of dollars in the 9 months ended this year and compare that to last year, it's a significant increase in the growth in dollars. So certainly, like that's an important thing to look at. So I just want to be careful on like things don't always move up to the right in terms of how you grow. And certainly, Q4s are different than other quarters for us. But we're really happy with the momentum around Pega Cloud, the execution of sales and just the net ACV add that we've had year-to-date. So those are all -- we feel very good about the progress we've made this year.

Yes, absolutely. So now let's rewind it back to the Analyst Day. You talked about the path to get to $2 billion in ACV, and you had growth rates of 10% to 17%. What's kind of your latest thinking around the path to get there? And what's -- how should we be thinking about like what's the most likely outcome?

So -- and this will connect a little bit to the Blueprint point that you made a little while ago. But I kind of look at the business as if we had no new innovation like Blueprint, but we were just executing without external distractions like we had over the last couple of years, we did have one of those. Without those, I think we've kind of proven and demonstrated that we're like kind of a 10% to 15% range growth. I know it's a big range, but like we're something in the low teens grower. And I don't see a scenario where we're a sub-10% grower. But also to grow faster than 15% from where we've been, something needs to change from our current momentum. And I think that, that's where Blueprint comes in, right? So I think Blueprint is the wild card, so to speak, that if it has the impact that we hope it does, it gives us the opportunity to get into a different growth trajectory than that range that we've kind of been in, right, if you normalize for the subscription move over the last number of years.

Yes. Okay. Let's go jump right into Blueprint, and I promise we'll save some time to talk about cash flow as well. I know that's near and dear to your heart. But okay, maybe, number one, look, a lot of people aren't super deeply familiar. So walk us through what exactly Blueprint is? And maybe if we can give 1 or 2 illustrative examples, I think let's start with that, and then we can jump into some specifics around it.

Okay. So I'll give a little background on this because I know that someone that doesn't know who Pega is and doesn't know what Blueprint is, this will not make any sense if you don't give a little color. So let's go back to digital transformation. We're going to help clients go from a legacy application that is on an old database, was built on an old technology, maybe custom software. And they want to move to a modern environment, and they want to move to a more powerful platform like Pega. In order to do that step, the client has to sit down. Historically, the client would have to sit down with a global system integrator typically, maybe some people from Pega and whiteboard out, what are the workflows? What's the problem we're trying to solve? What does the application do? What are all the different screens that we might want to have? And that process can take -- could take weeks. It could take months, it could take years. And that becomes the biggest headwind to clients digitally transforming is just the time and the cost of the implementation, the capacity. So it limits how many systems they could pick. They might have 50 to pick from, and they may say, "We can only take on 3 this year." It's just too hard. And they won't even be able to evaluate the other 47. They just judgmentally like pick 3. They just say, those are the 3 that I think we're going to do because maybe people are yelling the loudest. So that's the world that we're in, in terms of digital transformation. That's why McKinsey would tell you that we're only 15% of the way to the cloud and digital transformation and most [indiscernible] want to be 80%. How could [indiscernible]? We've been doing this for 15 years. That's a real light use case why. It just a lot of resources. Okay. So we went -- we, like everyone else said, okay, what does GenAI do? We can leverage the models that we can do automated call wrap-ups and note summarizations and automated e-mails and all the things that pretty much everybody can do, right, with agents. And we did those. But in the middle of that, we kind of took a step back and said, what is the -- what could think about how we go to market, how we help our clients digitally transform. And we thought this concept, imagine if we could use GenAI, in more common use cases by that, maybe anything else [indiscernible] that use case would look like on Pega. And the benefit of doing that, you might say, well, can't you just do that like with ChatGPT and what do you need Pega for? Sure, you could. What you can't get is you can't [indiscernible] workflow application, and you don't get to leverage all the proprietary information that Pega has about all the vertical use cases. So we've then pivoted to say, let's do all the table of GenAl stuff. Prople are going to want to license. Let's figure out if we can build some changes how companies can digitally transform. That was what Blueprint does. And it's one of Blueprint was literally [indiscernible]. You produced it. You've seen it. You type it on and it produced a PDF file like a little like -- almost like a Gant chart workflow. That was it for version one. If you fast forward to the version that [indiscernible], you can actually take shots, document material [Audio Gap] looks like the reformed new application that -- now if you want to say, if you don't like that, if you say, okay, but that's not really what I want because I want to change a couple of things. I have some new integrations. You can do it not by actually engineering it, and you could do it by chatting with the system. You're actually -- so that was our way of saying let's leverage innovation to completely change the pace and the maturity of digital transformation as an industry. Now if that happens, we'll get our fair share of those wins, right? Are we going to get everyone? I'm sure not. Is every company going to act on every Blueprint? Of course not. But it will help us differentiate the pace. Remember what I said at the beginning, the biggest headache, the biggest headwind to digital transformation is the cost of implementation, the time and the resource strain to be able to do and if Blueprint can fix that -- sorry, long-winded, but that's the connection of Blueprint to the value proposition.

Super helpful. Let me just follow up on that. What's driving what seems to be this uptick in Blueprint adoption and usage? And how should we think about the monetization of it?

[Audio Gap] to go through the system. So we want more transactions. The more transactions means more value that we're automating for our clients. The -- I think the -- what was the first part of your question?

Just what's driven like...

Yes. So Blueprint adoption,sorry, Blueprint adoption is -- so I think there's 2 things. One, nobody in the industry, and if you're curious, you can talk to partners, talk to clients, talk to the analysts. There are -- as I know, no one in our competitive landscape that has done anything like Blueprint. There are probably companies that have thought of things that might seem similar to it. But for us, it's an innovation that's very unique, right, and that is very advanced in terms of where we are. Might people catch up to us? Assume they do. What they don't have is they don't have the power of the Pega platform, which in every Gartner and every Forrester report is top and to the right in terms of technology. The reason why we haven't been able to grow faster is the pace of change that the clients can adopt. So Blueprint helps us solve the biggest barrier to entry that our clients have to using Pega, which is the time to adopt.

Yes. So I want to follow up on that because this stuff still takes a lot of time. But when you're talking to customers who actually want to use GenAI, what are you hearing from them in terms of concerns, right? Because a lot of the G2K has really been stalled out in their GenAI adoption, partly because of concerns around security and privacy. It still seems like you're getting real adoption there. So what's kind of that tipping point to get them over there?

So it's interesting. I was -- I'll give you just a perspective from feedback I got from some of my peers at a meeting that I was in. So GenAI has use cases where it's like perfectly designed for and use cases that it is not even a good fit. But I think we are so naive on what GenAI is, and I'm including myself in there that I think we're missing where the value is. So there was a CFO that was talking to me, and she was saying like, I really wanted to use GenAI because I want to automate all of my journal entries and all of my revenue recognition calculations and all of my -- and GenAI is not a good fit for that. You need to have precise, consistent -- they can't have -- if it gives 10 answers, the answer has to be the same every time. It can't be 10 different answers. So that's not a good use. However, sending out a collection notice, getting the e-mail back from the clients, figuring out what might be the next action to take, taking other data like was that client talking to someone in our support group, that might be a use case that could help you with collection notes, et cetera. So I think it's really important to understand what GenAI does really well. GenAI is not going to differentiate around structured data. Structured data with structured outcomes that have to be consistent like accounting, like compliance, like laws, like personal information, like sending a new credit card to someone, onboarding, managing a dispute in -- like those are not good use cases. However, unstructured data, notes, communications, things that need to be summarized, perfect use case, right, which is in a workflow system, much of the work that's done, it's that work. It's a human kind of stick handling the case through a series of steps with communications and notes and updates and observations, and those are much more subjective. That's a human typing something in. So GenAI is going to probably have a lower error rates than a human would have actually typing that information. I think once you recognize that difference, it all kind of like the clouds kind of dissipate a little, right? It's -- the problem is if you come in just assuming every use case, and I think that's the mistake we're making. And the large companies are also concerned about public information. So large companies like RBC do not want to expose even the search terms that they're using to anybody else that's out there. They don't trust it and rightfully so. They don't actually want to get the -- so once -- what's happening now though is you have the business-specific captive models. And that's where the future is going, right, where the client -- you have an LLM that's basically only using the data that's inside the company so you can choose what you use. And I think that's where the models are going to go. Like you can pick your own model, you can segment the data, you could choose not to use public data, you won't share any information. That's where I think large companies are getting more comfortable.

Yes. Okay. So I want to continue down that path because if we think about data, I think there's 2 things. Number one, LLMs will generate their own unique type of data that really just didn't exist before. And number two, as GenAI gets more adopted by enterprises, it may just completely change the way that we do things. What positions Pega well to take advantage of that new way of bringing in new data sets?

So I think that -- so there's 2 aspects there. One is what would make more companies move systems that should be workflow-based systems into a workflow system, just being focused on Pega that's going to help our growth rate, right? So with GenAI, the thing -- the differentiation there is speed of adoption, right? And then how do you leverage things like agentic AI on top of that workflow system to basically take the other human interaction that still remains after the system is built, things like automated call wrap-up, routing, using voice AI to communicate with people and leveraging the libraries to be able to create an intelligent agent to communicate. So there's -- the first step is getting people onto that workflow system where they've had some kludgy thing of like RPA connections or APIs and using Excel files and databases and getting them into that. And the second thing is now strip human interaction as much as you can. And that's really more the agentic AI kind of theme.

Yes, yes. Okay. Really helpful. And then maybe last on Blueprint, and then I want to move into a couple of other areas. But you talked at the very beginning in the past, you would work with these GSIs on these projects. How was the reception from the partners been around Blueprint? And is there a worry that there's some cannibalization there?

I think that's definitely a risk. I don't want to minimize that risk. But I will give you maybe an observation that we've heard from the system integrators. And I don't know, to be honest with you, if this would be what they would say on an earnings call. But like the system integrators make their money largely from the skilled value-added like the enterprise architects, the designs, the governance, the people that like they don't -- the business that is much more of a need to have is the kind of what I would call like the body shop work, which is offshore, low-cost -- for the work that's much more like building the stuff that GenAI could actually build. The second part of that is, and this is probably something many people don't appreciate. The front end of a sales engagement with a large GSI is largely done at risk by them. The business development activity that happens in that, they might -- they have to do free work. They're doing it with the hopes that they actually win the engagement. And they don't have a lot. Their margins aren't that great to be able to do a ton of that. Blueprint can take that out, right? If Blueprint can actually get the application to be like a working prototype that otherwise would have been the work that Accenture may have to do Pro Bono, they don't actually have to do that anymore. So we've seen our partners actually taking Blueprint and building their own Blueprints and then using it in their go-to-market. And we have 15 or so of our partners that have actually built proprietary Blueprints. We don't know -- you don't even know what they are because we allow them to [ segment often ] and have -- it's confidential what their actually use cases are. And they're actually using those, and they're differentiating how fast they can start a conversation with a client leveraging Blueprint. So although I think more revenue is better than less in the services industry, so I don't want to minimize that, the type of revenue that they're losing and some of the costs on the front end is not the differentiated value, right? They want the more -- to be honest with you, they want the more Cognizant, BCG, Bain type. They want the advisory, that higher-margin business. So they're going to be able to help clients digitize faster with better revenue, maybe reducing the amount of upfront costs that they have to do. So that's kind of our value prop to them.

Yes. Okay. So now you talked a little bit about verticals at the beginning. One vertical you mentioned was government. How should we be thinking about any impact from the U.S. presidential election going forward, including during the transition period and with the recent Department of Government Efficiency or DOGE, that's a real sentence I just said out loud, but how should we think about the impact of that on Pega?

So I wasn't expecting any change with this new administration. So no, I think that I think that there -- if you look at what Pega, where Pega is in the government, there are agencies, and I'm not going to get into speculation. There are agencies that we know will be targets. And there are agencies that we know that will be recipients of -- that's the way it is with any administration, right? But if you look at what Pega is focused on, I actually think it's very complementary to -- look, you can like them or not, Elon Musk saying that there are antiquated systems that are 50 years old that cost hundreds of millions of dollars to support the government is a true statement. I know that firsthand. So I don't think it's -- like I said, you can disagree with the approach, but you can't disagree with that. The systems and the government are old. And many of them need to be shut down, and many of them need to be modernized. And many of them need to go to the cloud. That couldn't be more congruent with our opportunity set, right, in terms of how we leverage that. Whether GenAI will be big there, whether the cloud will be bigger or not, which agencies, I think it's kind of a wait and see there. But there's no doubt that there's a recognition of antiquated systems. Some of those will be shut down. But many of those, it is time now to move and modernize those. Even in -- honestly, even in places that you would hope that the things would be more modernized like the Department of Defense, right? There's going to be -- there's antiquated systems even in places where you would hope that our technology would have kept up. So that's -- we view that as an opportunity. But I'm like -- your guess is as good as mine which agencies they're going to feel the tailwind and the headwind.

Yes. All right. So since you stepped into this role, you've been talking about Rule of 40 from day 1. You're getting very close to a Rule of 40 territory. What's been driving that? And what have you done to align your own employees with that Rule of 40 mindset?

So it is -- it was really hard going through the subscription transition, just to be honest with you, because the Rule of 40 makes sense when your business isn't [indiscernible] transition, right? So what happened is the first -- my first -- I mean it was within the first 30 days, I actually had -- I went out to employees, and I basically have the slide deck that I did that is like not all that sophisticated, but it starts with like, how is the business value? Cash is king. Let me talk to you about the way companies value. Why do they use revenue multiples? It's really a proxy for future cash flow. Like I just went on like an education, right? And I would say that started to catch on, and then we went through the subscription transition. And employees would say, I don't understand why our revenue is going down. I don't understand why we're using -- like losing money. And I had to like really be patient to explain to people like we're going through a subscription transition. Let me show you how the billing changes. So now that we're on the other side of that, admittedly, it is easier, right, because the business -- we're not completely normalized, but much, much better. So what's happened now is 3 years ago, we sat down -- I sat down with employees, and I said, here's our 3-year plan. We're going to be a Rule of 20 company in 2022. We're going to be a Rule of 30 company in 2023. We're going to be a rule of -- and if we do that, here's what we should expect to happen. And largely, we have executed to that plan like pretty close. And we have the benefit of when we actually make progress with our strategy around Rule of 40. Rule of 40 for us is have the highest profit margin but don't lose efficient growth opportunities, meaning grow as fast as you can as long as it's efficient growth and have the profit margin that supports that. That's our -- that's Rule of 40 as a theme. And I think what's happened is, as we've executed and the stock price has reacted to our execution, employees buy in more and more, right? If we had made these comments and then the stock price went down, employees would say, I don't understand. We're doing everything that you said, Ken, and the market is not rewarding us for that execution. But given that -- and I wasn't really that concerned because I knew if we executed, the market would reward. So that's kind of where we are. I have been -- like I came from private equity, as you know, Rishi. And the thing that I really dislike about private equity at the earliest stages was that's not like that now. Private equity is not like this now, but it really didn't know how to run growth companies and actually do margin expansion at the same time. That's what they saw. They were unbelievable getting margins to 50%, but wasn't as great at supporting innovation. I think private equity because when I started, it was like $100 billion industry versus what it is now. But I think that they've really pushed like their -- private equity firms are just as good as anybody else at actually supporting innovation, but they have good operating discipline. That's like -- it's in my fabric. So going through the subscription transition was the hardest point in my career because I had to explain to people that the numbers couldn't tell you anything about where the business was going, then that's the -- well, thankfully, we're through that. And that's why -- by the way, that's why I pointed to ACV, as all of you know, when I just pointed to ACV saying, that's the measure because ACV is billings, and billings are what matter. And we'll come out of the other side as the business then played out.

Yes. Awesome. I think it's a great point to step up. I wish we had 10 more minutes, but this is super helpful.

Awesome.

Thank you very much. Thank you, everyone.