Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

All right. We'll get started here. Welcome, everybody, for joining us today. It's Day 2 of the KeyBanc's Emerging Technology Summit. My name is Devin Au, and I am part of the software research team here at KeyBanc. We are very pleased to have Pegasystems and the company's CFO and COO, Ken Stillwell joining us. Ken, welcome.

Thanks, Devin. Appreciate it.

Yes, thanks for coming back. I really appreciate it.

Absolutely.

Maybe just a warm up for the crowd and for the investors who are unfamiliar with the company, can you just give a brief overview of what Pegasystem does. And I think the product and platform has evolved quite a lot in the past 3 to 5 years. So why don't we just start from there.

Sure. Pegasystems is in the workflow automation space and workflow automation is commonly think about it as when companies that have some level of scale transactions and maybe using disparate systems for certain parts of a workflow, that work needs to be managed. It needs to be organized. It needs to be orchestrated and that involves a certain level of rigor and structure as the workflow gets done. So certain steps, certain stages, how the work gets done, the integrations, what things are captured, communicating with a client -- or excuse me, to a customer, and so there's lots of use cases -- common use cases are things like in the customer service channel is a very common use case, or things like onboarding in a health plan or an insurance policy or renewal -- quoting for insurance or things -- everyday service things like I lost my card for a credit card or -- so you could just -- there's quite a broad set of use cases. The most common ones are things around like things like managing exceptions, managing disputes, managing customer service, onboarding clients, offers in digital channels like a credit card company. But those are some real-life examples of how we manage the orchestration of that data. The thing that you referenced about the journey that we've been on over the last few years is we made a very hard move 5 or 6 years ago to go to the cloud. And we've -- right now we went from our business being less than 5% of the cloud, 5 or 6 years ago to the cloud is now about 50% of the business. So the majority of our net new business is on cloud, and we've started to work with some of our clients to move some of their historical they were managing themselves on to Pega Cloud. And more recently, we've really leaned in hard into Gen AI, which I'm sure we'll talk about later.

Awesome. No, it's a great overview. A lot of things I want to get into, but maybe a first place to start, I just want to maybe double-click on the opportunities that you're kind of pursuing with Pega. Maybe just double-click on what are you guys displacing when you guys go to market, the tech stack that you guys are kind of going after, but also the budget and buyers you guys are going after when you go to market with Pega?

So typically, the buyers, the decision makers for an opportunity that Pega that would win would be maybe kind of the most common ones would be like a Chief Technology Officer or Chief Operating Officer for a business unit inside a large organization. So like, for example, the Head of the Commercial Bank of a large or the head of an investment bank or wealth management. And the CTOs, typically the way a firm like KeyBanc is organized is you'll have the business units and you typically have like a head of the business units and then you have CTOs that actually run the technology strategy for those as a partner. And then you'd have a centralized kind of CIO or CTO organization that maybe did the majority of the work, right, that managed that -- so we would have sellers -- the buyers would typically be the business unit owners and then the influencers would typically be the CIO or the technology managers of kind of what's the standard delivering that service. The -- I would say the -- probably the most interesting dynamic around that buyer journey is that the biggest challenge is to get into an organization, right? So that's probably a very generic comment that applies to lots of software companies because once you get in there's a real opportunity to expand and grow inside there, which is why the majority of our growth does come from the existing logos that we already do business with because. But frankly, there's just -- there's more velocity and less friction when they already know you, you've already -- so getting a new logo is really helpful and important but typically doesn't come with a lot of ACV or ARR at the very beginning. It normally sets the journey for where you could upsell and cross-sell to them over time.

Okay. Yes. I want to just quickly follow up on your expansion opportunity. I know Pega has had tremendous shop, really sticky software, right? You guys have essentially zero churn and you guys have been able to sustain that 10% plus net expansion for quite some time. Maybe just kind of talk about how much or what the penetration is among the installed base? And how much more room can you guys penetrate in the long term?

So I can maybe -- it's -- admittedly, it is imprecise to try to get to too scientific on that number, so just full transparency. But I can give you a couple of pieces of information that can help to gauge that. So if you talk to AWS or you talk to McKinsey, they would tell you that enterprise clients are anywhere between 10% and 20% of their way on their journey to the cloud. I think 20% is actually pretty high. I think 10% to 15% is probably more likely the number. Matt at AWS, I think, in one of the conferences like in the fall said that he thought it was under 10%. So it's not a big number, right? So let's just say that we're 10% to 20%. Pega has an opportunity to be part of that journey with every single client because the majority of applications that are not on the cloud, that could have been written in COBOLt that could have been in some [indiscernible] -- there's just all these old older systems that need transform. They're not on the cloud. They're not on legacy, they're not on new technology. They have all kinds of vulnerabilities with operating systems that aren't supported by large OEMs like Microsoft and others. And so it's really a very bit liability and they've got to get those to the cloud. So if they're 10% to 20% of the way there and they want to get to say 80%, which is the average number that CEOs and CTOs would say, we're in the early innings of that transformation. So then when you look at our clients, if you look at Pega and say how penetrated is Pega around the largest clients that we have, that's kind of I like to look at the largest ones. I would tell you, we have a handful of clients that are of reasonable size -- reasonably bigger than $10 million a year. And if you look at what we could actually do with those clients, I don't see any of them where we're 25% penetrated. So in the most penetrated clients we're probably 25%, maybe 30%. In the average client that we have, we're probably low-single digits penetrated in what we could sell. Now some of that ties to that journey from 10% to 20% up to 80% of the cloud because a lot of those systems are workflow systems, that Pega should be able to get at bats on.

So still a lot of room to grow.

I think almost -- it's almost hard to believe that a company can grow low-double digits for decades and actually still actually have that, but that's the reality of where we are in this journey.

Okay. Got it. I want to switch gear a little bit and just touch on competition. I think that's an area that we get a lot of questions by investors. And I know you guys have been around for quite some time, and I just want to maybe ask about if the competitive landscape has changed, especially with the rise of AI and Gen AI could you just kind of briefly speak about that.

So it's interesting. It's probably -- I will touch on the Gen AI piece, but I'd say just on the down the middle competitive landscape, it's probably one of the least interesting answers that I can give because it's been the same answer for 9 years, which is the competitive landscape largely the same people that we saw 10 years ago. There's just not been a lot of change, right? It's -- and I think some of that is because if you think about which companies can do work automation at scale with a platform that could actually be configured and dependable to drive that level of volume, there aren't that many, right? I mean there's less than 10 for sure, probably more like less than 5. There are spaces that creep around workflow. For example, RPA was one a few years ago. Where RPA came on the scene and immediately, everybody said, "Oh, RPA will replace workflow." You can -- well, that clearly has not happened. I think there is a space for RPA, but it is -- it is typically done in systems where you don't need to actually have an enterprise workflow with volume. It's typically kind of like legacy system, trying to grab data, there's not API. So there's a use case for it, for sure. Then there's Gen AI comes on the scene. And naturally, the paranoia is, oh, Gen AI will -- you'll be able to just go into a prompt and say, "Build me a customer service application. Gen AI will magically build this application for you. The reality is there are plenty of amazing Gen AI use cases. Quite frankly, I think it's much more real than it is fantasy. But unless you do not care about how the work was done, and you only care about the outcome, and there are use cases for that, Gen AI doesn't work. Gen AI only works when you only care about the outcome. If you need to actually have an audit trail of actually all the steps, all the stages say, you can go back and look at every loan that KeyBanc gave and determine, did you follow your process, any discriminatory lending issues? What exceptions did you have? All that, Gen AI doesn't have the ability to track at that level, the structure. It's unstructured, which is the beauty of it. It's not structured. And so I think that the trick in Gen AI is how do you use that unstructured powerful large language model in the context of a structured workflow. There's 2 ways, agents is one, right, which is you hear that commonly talked about with vendors or with companies like us. And the second one, we think is very unique, which is Blueprint. And we can get into Blueprint when you when you feel it's appropriate. But that's kind of -- we took 2 approaches. One was to leverage Gen AI to be able to take human tasks out to automate, to drive decisions, that's the agent approach. And the other one was to break the biggest problem that software companies have is it's too hard to digitally transform legacy transfer. It takes too long, a lot of implementation, billions of dollars, decades of work. And what Blueprint was really intended to do was to leverage Gen AI, try to speed that process up.

Yes, why don't we get into Blueprint a little bit because that's the product that you guys launched, I want to say, around a year ago, right? And you guys have seen tremendous adoption, really good feedback, maybe just for the investors in the room that don't know what Blueprint is? Just kind of walk through what that product is, but also how does it generate value to customers?

Sure. So I'll start with where I was just going, which is if you're going to take a legacy system that might be in, say, on a mainframe system written in COBOL and you need to get that application into the cloud. You're not going to pick that up and move it, right? One, many of the things you did were custom. There's all kind of vulnerabilities I just mentioned. There's open source that you can't put it. Like there's just a million reasons why -- so you have to -- the question is, do I just start over again and build a brand-new app in parallel and migrate the data over, that's typically how clients would go at it. Very cumbersome, very expensive, has to be done, but that's the reason why we're only 10% to 20% of the way to the cloud because that's a complicated thing. What Blueprint tackled -- what we came when we saw Gen AI we saw a different opportunity around Gen AI, which is if we can build an application that has a front end that essentially takes input of information. It leverages all of the content that Pega has had, content around best practices around how workflow should be for certain use cases. Everything that would help you know how to build that workflow that's sitting in this legacy mainframe system. And we could automate the build of that application on Pega, you're using the structure of Pega, the knowledge of Pega, and you're essentially letting Gen AI build the configuration for you, similar to what an agent could do to be able to work on an application. If we could do that, how much time could we compress that process of ideating the discovery, all the planning, all the collaboration, the architecture diagram, the white boarding, the PowerPoints, the Visio diagram, all the things that happened to redo that out. If we can replace that with a 2-week session, where you enter some information in with an actual agent assist there to help you get through that. And on the other side, it built the app that you could literally put into production, which is what we have right now. We could go to every client and say, I know you wanted to get off that application. What if we could give you a path at 6 months, not 6 years. Now that doesn't mean clients just all of a sudden have money to be able to do all of that at once. But it does -- it should give us a kind of a -- it put us in a position that gives us our right to have those conversations, to have those -- and to help clients pick which ones and to speed that up. It should at least have the time of implementation in terms of the time and the effort. And so that's the value proposition of Blueprint that we've been rolling out. We've had -- we're approaching 100,000 blueprints, right, that have been done with our clients, our partners, and we've had massive adoption with our partners. If you -- for those of you that have done channel checks, you know that's true because our partners are talking about it. We've had incredible excitement with our clients, we've actually become -- we've got into different conversations that we've ever had, just because being able to show them the Blueprint technology, it gives the perception of, wow, Pega's innovation is that we're -- because Pega has been a software company for 40-plus years, there's this -- and we're very sticky, and we've done systems that would be considered legacy in some cases. There's this perception that maybe we're not who we are, right? You're an old software company that -- but to this -- what Blueprint has really done is just reinforce like we've been an innovator like we've been at the forefront of innovation. So -- so that's what we're most excited about. We just rolled out Blueprint to our sales teams to use at our sales kick off at the beginning of the year, so that was January. So we just rolled that out to our sales teams and they're essentially pushing Blueprint through our selling channel, which means all of our new campaigns starting right now are going to be leveraging Blueprint.

Okay. And maybe just a quick follow-up there. The most important question is how are you guys monetizing it? I'm guessing you guys aren't really directly monetizing it. Maybe just speak to that a little bit.

Yes, good question. So Pega sells, the way that we sell is we sell based on the volume of activity or business that the system does. We don't sell user-based licenses. We basically sell what we call a case, a case -- think of a case is like a unit of measure. So that could be a certain number of cases might make up a loan origination or a case might be every time you have an address change. So the more the more we think our client should actually share those savings with Pega. So just think about that case. If Blueprint is not going to be sold, it's going to be used to drive more solutions, more applications, therefore, more case volume. So the way we monetize that is we get more activity with our clients that then will be converted into cases, which is the unit of how our clients pay us in a subscription model. So that's the way we monetize it.

Okay. Got it. I want to maybe just also want to quickly touch on the fourth quarter results that you guys just put up. You guys finished the year with ACV growth of 11%. You guys are guiding to a slight acceleration in '25. Maybe just give us a quick thought on how you guys are thinking about that growth target that you guys put out, but also how do you reconcile some of these strong momentum you've seen from Blueprint, how does that kind of be embedded into the guidance?

So the guidance that we had was -- we modeled a slight acceleration in our ACV. And that slight acceleration, where our view is some small momentum from Blueprint bookings, things that were driven to an actual book deal will happen in '25. But we're trying to be more thoughtful around listen, we just rolled this out to our sales teams. This is a behavioral change in our selling process. '26, '27, '28, those years, we think Blueprint will be well anchored and every pipeline deal will be Blueprint. And you will obviously see in the results whether we actually get that uptick in our growth rate from Blueprint. That's not to say we can't see it in '25. We just didn't guide with the expectation that we would. So -- and largely, I don't -- I wouldn't consider that to be like a conservative guide or not. I would just say the reason why we didn't is we were just early -- we're early in this adoption process. We just didn't feel like we had the level of visibility at -- on February 14th to say, this is what the future is going to look like. As we get through the year, we will obviously see how it's rolling out. And each quarter, we'll have more conviction on when we might see that. But at this point, we just guided with very little impact.

Okay. No, I guess we'll have to progress and see how it goes through year. I want to also touch on free cash flow, which I heard is a topic that is near and dear to your heart, Ken. You guys guided '25, $440 million, which implies, I think, near 30% growth. I thought that number was maybe missed by some investors on that print. Could you maybe just talk about the drivers of that strong growth and think about the sustainability of that going forward?

Sure. So just to be completely fair, the right apples-to-apples number is probably the $338 million that we did and add back the shareholder lawsuit settlement of $32 million, and that would be $370 million. So if you really wanted to be just to not take credit for too big of a growth, I think it's more $370 million to $440 million, which is about 20%. So I would just say, just like full very direct person. So I'll just say, just to be fair, 20%. 20% is still I'm pretty respectable. And I think the reason why we can get there is we still have opportunity for operating leverage in the business. I mean, our sales and marketing costs are still above 30% of revenue. And at our growth rate, we feel like that number should be coming down under 30%. Our gross margins are not quite to 80% there, although we're not going to see a big uptick in that operating leverage in gross margins for this year, there still is upside there. our G&A and R&D, we think, is a reasonable level. So you're getting a little bit of operating leverage, so we're able to grow free cash flow a little more. But I think the thing that -- the point you're on, which is people may not be catching that as much, I think there's a little bit of a trend that this may actually be the last year for this. But I think there's still some skepticism on Pega's cash flow trajectory because it's still new, right? We did -- 4 years ago, I went out to investors and said, "We're going to be a $300 million cash flow generator soon." And some investors said, "No, I don't know if I believe that." And then when we became $300 million, before when we were about $200 million, I said we see a path to be a $500 million free cash flow. And I think when I said that, some investors said, "I don't know why you said that you're not going to be at $500 million." So now where you could see at $440 million, $500 million is just right around the quarter. So I do think we're still only a couple of years into that. So I think there may be a little bit of caution with investors looking at that number and trying to figure out like is that a onetime thing? Did you have some billing anomaly? Did you -- and what I would just tell you, without a second of pause, there is absolutely nothing we are going on in our free cash flow. Billings are ACV. We bill our costs are largely cash costs and the business is just expanding margins as we get.

Okay. Maybe just quickly touch on that. I think the $500 million target that you guys kind of provided at Analyst Day free cash flow that is, I mean, you guys are generating pretty close to that today for this year. I mean do you guys have any updated thoughts on that target? It seems like you guys could grow free cash flow a little bit above ACV annually. Just any updated thoughts on how you think about the targets that you put out.

Yes. Just -- so we'll give some more visibility at our Investor Day in June, but just to kind of close that point for you. Two years ago, we actually set a target in 2026 for $500 million of free cash flow, after tax free cash flow. Last year, we said maybe that will take us an extra year. So we kind of pushed that $500 million out to 2027. The momentum that we've had both in '24 and in '25 suggest maybe that number could come back in again. So it's kind of somewhere in the range and -- and I think that, to be honest with you, this will probably be the last year we talk about $500 million because there's probably a bigger number that we need to be focused on right now in the future. The one thing that we're very committed to is we're committed to growing free cash flow faster than ACV and buying back shares such that we can actually get a free cash flow per share that's higher than that. And I think now we're in a position that we have a lot of cash or generating a lot of cash, and we don't have anywhere near that level of dilution. So we should be able to start to bring down our share count.

Okay. I think we have like a minute left. I just want to check and see if the audience has any questions. And then...

With all the free cash [indiscernible] following up on the M&A? Or is it [indiscernible]?

I think actually M&A becomes -- we have -- in the past, we were only generating $50 million free cash flow, which, by the way, was not that -- when I started, we were doing like $38 million of free cash flow a year. So we couldn't really do more than tuck-ins, right? We just could -- and -- and I think when you're generating $0.5 billion of free cash flow, and you have the ability to lever on that, too. I think it definitely opens up different types of acquisitions. To be honest with you, I'm less interested in doing technology tuck-ins and more actually, if we were going to buy something, something that's actually at scale, that has a defined market that may actually be cash flow positive already. So -- but I'll say, we also are very committed to certainly at valuations where we see them now. We think buybacks are a great use of cash for our shareholders.

Awesome. Well, with that, Ken, really appreciate it.

Thanks, Devin.

Thanks for joining us.