Pegasystems Inc. (PEGA) Earnings Call Transcript & Summary

All right. I think we're ready to kick things off. I'm DJ Hynes. I'm the senior software analyst here at Canaccord. This is the 45th year that Canaccord has put on this conference. We couldn't do it without the corporates that bring all the content and the interesting businesses and the investors that invest the time to come and ask the smart questions and eat all the food. So we're thankful you guys are all here. We're thankful to have Pegasystems with us. We have Founder and CEO, Alan Trefler; CFO, Ken Stillwell. We're going to do this as a fireside chat. So happy to integrate any questions from the audience, just raise your hand, we can work them into the conversation.

But maybe just to kick things off, Alan, it'd be great in case folks aren't familiar with the Pega story. Just talk a little bit about the problems that you solve for customers, the types of customers that you work with, what Pega does.

Sure. What Pega does is we have an AI-powered workflow and decisioning platform that mostly very large companies use to take their sophisticated workflows, the things like customer onboarding, handling disputes, providing better service and make good decisions for the customers and then be able to execute effectively. And we've been working to incorporate AI in a very novel way using a technology called Blueprint, which has had massive impact on our business in the last couple of years.

Can you talk about some of the major verticals? You referenced large customers, enterprise.

We started in financial services, where we, for example, our first 2 clients who got forbid, went live literally 42 years ago. Citicorp went live in 1984, Citicorp and Bank of America.

I'm 42 years old.

You could be a new system. So the reality is, obviously, the technology we run on has changed staggeringly literally 5x in our relationship with those customers. But in terms of things that we value as an organization, having what are actually extremely large relationships with those 2 organizations as well as many other financial services companies is something that we value. We do quite a bit of work in the health insurance business, working with the leading players, not just in the U.S., but also, for example, [indiscernible] down in Australia. And we do a lot of work with governments like Her Majesty's Revenue & Customs. We have a major engine behind how they provide service, probably 50,000, 60,000 users there as well. And we work actually now in a number of other industries. We work in manufacturing and pharmaceuticals because lots of places have workflows. We think life is a series of process-oriented flows that you want to be able to do in an organized and structured but highly responsive manner. And that's what Pega tries to do.

Yes. Typically, the business model, just to add to that is there's normally a consumer constituent on the end of that, right, which drives to lots of transactions, maybe many times regulatory standards around like the Fair Lending Act for loan origination, et cetera. So that's the way to think about the businesses. So it's really not limited by use case, but it really when you think of scale, scale transactions with a B2C or a B2B2C type business, that's the most common.

Yes. Perfect. Typically, we dig in on Q2 results. I'm going to skip that question for now. Q2 is another nice quarter. I want to ask you a bigger picture question if we zoom out, like how are you positioning the Pega story for investors these days? And how do you see it kind of evolving over the next few years?

Well, the enormous hype around AI and what it means, what it doesn't mean, et cetera, is of great interest to us. We were doing AI before it was fashionable. In 2010, we actually bought a company that was a leader in statistical AI. Statistical AI is being able to do machine learning, basically be able to find patterns in transactions and numbers. And we still believe very much that statistical AI is extremely relevant. And it's very important to a lot of our clients. It's used to do by like Verizon to figure out the next best action they want to do relative to their individual customers and to be able to do that in real time. But the generative AI capabilities have really taken over a lot of the dialogue in terms of how things apply to technology and how things apply to customers. And we've come up with an approach to incorporate generative AI in a way that is really quite unique and structurally consistent with the way Pega works. And that is we use this generative AI and the power of that collaboration you can have with it to help you design tremendous numbers of beautiful workflows to really describe your business. And then at run time, when you actually want to do something, we're not using the AI to reason and make things up. We're saying, hey, we'll just find the best workflow, use the AI to connect the language to that workflow, but we'll be able to operate in a predictable and reliable way that is uniquely supported by our technology because we have such a powerful workflow engine. So we're using what we've developed and iterated on for so many years to be able to bring value to the AI. And somebody who has a computer science background, I look at a lot of the conversations here, and we certainly belong in the trough of disillusion compared to some of the things that are being said. I feel that we've done a really good job of finding the right way to hit the right nodes here.

Yes, yes. Maybe I could ask you a non-Pega specific question, but we've been doing a ton of these fireside chats with software companies. We've all seen how the space has traded off of Q2 earnings where I felt like results were generally pretty good and the stocks struggled. I think there's the narrative that's bubbling up, whether it's tied to GPT-5 or whatever that AI is going to kill the SaaS category. What's your perspective? What do you make of that?

I think there are some companies that will be under stress. I think we will not be among them. The reality is that GPT-5, which we've been using for recent days, like a lot of folks have, right, is interesting and powerful, but still has that lovely ability to hallucinate occasionally. And also, candidly, who wants to run their business in a way that you can't describe in advance. The whole idea of the people who are promulgating the death of SaaS, I think, are after use cases where it's not important to have processes. But all of our customers are at places where being able to have processes and being able to explain your decisions, which none of these AIs do a very good job of explaining the decisions are really key. And I think that for some of the SaaS companies like us, that's going to continue to be not just of importance, but of extreme importance. So we feel really comfortable. And of course, we're happy to use these advances in the foundational models like GPT-5 or like Gemini from Google. We use those very aggressively to be able to make our software design better and to make our software execute better. But I don't see them as the sort of mystic threat that I think has been taken over the market. And I do think some customers -- some companies are going to be overrun. But not the types of business we do with our clients.

I think if you think about -- I don't want to point out any vendors or companies, but I'll talk about use cases. If you're an application, if you're a software company that helps people build websites or manage data, like do data analytics and create dashboards, a lot of those things can be done really efficiently using a model. And to be honest with you, there's not really a right or wrong way to put a dashboard together. It's information. And what -- so I do think that there are -- there's going to be disruptions. But when you require either through your own controls or through some other regulatory or law or standard work to not just get done, but to be done in a certain disciplined way to incorporate certain information at certain steps to be able to -- I think it's going to be very hard to get around that requirement. And the models will get you an answer. And even if the answer was right, that doesn't solve the problem of how did you get to the answer? And did you comply with certain -- and so that's -- when you think about -- go back to what I said earlier, we sell to companies that work with consumers and constituents, and there's not -- there's very few countries in the world that aren't focused on protecting their constituents and consumers from bad actors, from misuse of data, et cetera. So I think there's a lot of complexity there that I have not seen or heard any use case from Gen AI that solves that problem. And so that's where I think -- there are going to be things that are disrupted, but I don't think when it's you need to do the work in a certain structured way, use AI around the workflow to drive efficiency to take human interaction out of it, et cetera.

Yes. Good. My wife will be thrilled to hear that SaaS is not going away. I may still have a job in a couple of years. That's a good thing.

You'll certainly have things to analyze. I'm glad about that.

Well, in 2003, I think they called the death of mainframe. And it's larger now than it was. So I mean, let's just go pattern recognition.

Let's double-click on AI, specifically Pega's AI blueprint and kind of how you're working with customers and how you're seeing them incorporate AI to change the way that they build applications and workflow.

So what's interesting is, I would say, in the last year, we've had over 100,000 blueprints created by customers or partners. And for us, that's just a mind-blowing number. We're a company with fewer than 1,000 customers. We've been highly concentrated in terms of how we've operated and gone to market. And so we've seen enormous enthusiasm from customers in terms of using this to ideate and to try to figure out what different things they can do. And we're starting to see it actually lead to faster delivery cycles and more effective delivery, not just faster, but -- not just more creative but also just better outcomes, and we think that's exciting. The interesting thing that we announced at PegaWorld in June was the work we're doing with partners where we've now created the ability for key partners of ours to be able to create their own branded blueprint which will contain their intellectual property. They can put their intellectual property into a database on Pega Cloud. We will preserve it. It's owned by them. It belongs to them. It's not visible actually to us. But if one of those employees, if somebody from Ernst & Young, who's an employee of Ernst & Young, goes and deals with an Ernst & Young customer and they want to bring up Blueprint, it will be branded EY. And if they want to do digital transformation or with their own projects, we'll use Blueprint to do the creativity, how do you really want this to work? How do you want it to go and actually turn that into something that can be experientially touched and used. But now we can do that, I think, promoting our partners as being both vehicles and force multipliers for the way that works. And this is very young. I mean this is just coming to market now, but I think it's super exciting. And the fact that so many of the partners are interested in doing that, I think just validates to me the power of this, that this is a unique way for them to engage.

Are you seeing an acceleration in legacy application replacement, would you say? Or is it just kind of steady? And I guess what are the triggers inside of a customer that kind of catalyzes that step?

Well, SAP has been a major interesting trigger of late. They've been pretty aggressive about telling their customers that they want them to go to the cloud. And they've put short-term dates in. It feels a little like tariff sometimes. You got to do it by here, okay, we'll give us more time. But let's face it, this move, this push to the cloud and to S/4HANA is coming, whether it's on cloud or on-premise. And they've come out and said they want their customers to have a clean core, which means they want the bits of SAP that do the accounting and the central elements of it to be clean, to be pure and not customized. So they've given customers the mandate to go and take all these customizations they've done historically and figure out how to replicate them or otherwise do them not in the core of SAP, but either in an SAP process automation platform, something called BTP that SAP has or somewhere else. We're an awesome somewhere else for that. And so I think that you're going to see some structural elements where a lot of these systems are either end of life or being pushed to different ways that make the businesses say, we got to get rid of this old stuff. And I think that's great for us.

Yes. I think a couple of other accelerants around digital transformation, legacy transformation, app modernization, whatever word you want to use to describe it is there was a -- large clients started to move. And I think if you ask AWS or or Google or Microsoft, they probably say we're 10% to 20% of the journey of getting through these apps to a more modern kind of hyperscaler or cloud environment. I don't -- it kind of sounds shocking to think it's that low. But if you look at pretty much anybody and you go talk to clients, they would kind of confirm that it's somewhere in that range. You're not going to get to 100%. Say you get to 80%. So there's a lot of room to move there. Two things that have, I think, put fit fire underneath. One is the security challenges around congruency between all the different versioning and like life cycle and end of support type situations where clients like, I can't even certify this system. I can't even comply that this system. Second thing is you can't really leverage Gen AI in a real way on an old on-premise isolated system. So you need to monitor. If you're going to use that, you can dump all the data somewhere and you can try to manage all these data lakes, but I don't know that that's really -- that's really not solving the problem. So I think there's some things happening in the industry. If you look at the top 3 trends, the top 3 trends are AI, cloud, transformation, like those are the top 3. Transformation was not in the top 3 until AI got in the top 3. And now -- so I do think there's a connection there between the 2 of those.

Yes. Let's maybe bridge some of these business tailwinds into the business model a little bit. And maybe this one is for you, Ken. But I feel like over the last few years, first, it was kind of the focus on the move to subscription, then it was the focus on Rule of 40. Talk about kind of progress against those initiatives and where we are today.

So I think I'm -- probably the thing that I'm personally most proud of for the company is that we said we were going to do 3 or 4 things over the last 5 to 7 years, and I think we've done them well. The first thing was we said we're going to move the business from a largely perpetual model into subscription model. Right in the middle of that, we kind of pivoted a little bit and said, wait a minute, cloud, right? Because everything was moving to cloud. We weren't really pushing that as hard. At the time we made that shift, we were 2/3 of our business was perpetual, 3% was cloud. So fast forward today, it's all subscription and more than 50% of our ACV is cloud. So I would consider that to be good progress. The second thing we said was that we were going to become a Rule of 40 company, which -- and we were going to kind of go through the the trough and deal with it, and we did a convert to help fund us through that. And that was very messy because although companies have done it, it's -- I think there's -- most of you in the audience that are investors and analysts probably have seen a number of companies and not the least of which was Adobe when they made their switch. So you can kind of predict how it's going to play out. But I think our model played out pretty close to what we said. We're probably about a year behind in terms of the transition. And that was really getting that over and fixing the margin profile and the cash flow at the same time. We also did a sales transformation in the middle of that, 2 phases of it at the end of '22 and toward the third quarter of '23, I believe it was. So I feel like we've done like all this good work. And where we land today is with free cash flow margins approaching 30% with room to go. I think the ACV rate has actually started to accelerate over the last 2 years. Our sales efficiency has never been at the level that it is. And we've got more than 50% of our ACV on cloud and 80% to 90% of new growth is cloud. So that's a lot that we did in the last number of years, but I think we've done it pretty well. And I think that when now we sit in a business that we're generating pretty reasonable amounts of free cash flow and have -- that affords us all kinds of flexibility in terms of capital allocation, et cetera.

Yes. Yes. Maybe we're talking about margins, you do have some intermediate-term goals out there for '28. I think you've talked about $700-ish million in revenue and now free cash flow. Today, I think in '25, you're going to do like $440-ish. Help me think through like the bridge to get you to $700 million in '28 and where the leverage is in the model.

Sure. So maybe a recent tweak for '25 and '26 that I've started to talk about is with the changes in the capitalization of R&D in the One Big Beautiful Bill legislature -- legislation, we're going to probably reduce our tax liability in '25 and '26 because we'll get to deduct a lot of R&D. So that will help our cash flow and even what we originally thought for 2025 and '26. That said, that will normalize when you get to '27 and '28 in terms of the margin. Really, if you just take our business and you grow ACV low double digits, and you show some small improvement in gross margin just based on the mix of Pega Cloud, I'm not talking about going from 78% or 79% to 85%. I'm talking about going from 78%, 79% to maybe 80% or 81%. You get -- you just continue the progress on the sales model that we have, you'll see our free cash flow margins approach 35% in 4 years. And that -- if you do the math on that, you'll get above $700 million. So I don't think it's -- when I told the Street 5 years ago, we were going to do $300 million in free cash flow, I got a lot of snickers, right? Then when I said $500 million, I had people pull me aside and say, why would you tell the market that. You're never going to be able to do that. When I said $700 million, nobody better than I. I said, yes, okay. That makes sense. So I actually feel like that's a win for me, right, it's like -- it wasn't really -- it was believable to me, but it was hard to see when we were losing money to see how you get to $300 million. Now I think you can kind of just model out and you can see.

That's a little bit more of a glide path.

Yes, 15% kind of growth in free cash flow. It's not -- that doesn't seem hard to do when if you're growing ACV low double digits. And I haven't even talked about buybacks, what we might be able to do with the share count for free cash flow per share. That's just straight free cash flow.

Breaking news at the Canaccord conference, buyback. Joking. Okay. Alan, to you. So you recently announced a partnership with AWS. I'd love to talk a little bit around how Pega and AWS and maybe some of the large SIs can work together on modernization programs for your customers.

Well, going hard at legacy transformation and modernization is something that particularly -- coming into this year, we said we want to do things to make that happen. And we've been doing a lot in Blueprint to facilitate it. That work is ongoing, but it's very exciting. We -- my Head of Product at PegaWorld, if you want to see a really interesting video, Kerim, who been with us over 30 years and runs our product development. He basically took a video that was recorded of a woman playing with a 3270, that's one of those ancient IBM mainframe apps doing credit card-related processing that had no documentation. And he took 10, 12 minutes of that video. She talked about what she was doing, dropped it into Blueprint and literally in real time on stage, what it did was mind-blowing in terms of being able to get you not just a starting point, but deep in how you would go and go after those sorts of systems. So Blueprint is an enormously powerful factor. The partnerships are huge because with both AWS and also we're partnered deeply with Google, but AWS has made a very strategic commitment jointly with us. They're giving us a level of visibility. We're at their conferences. We're doing joint marketing together. We're working with our sales force. Our goal is to be able to recruit members of the sales force of the big partners like EY and Accenture and organizations like AWS and get them to bring on Blueprint using the brand Blueprint. Each of them have a branded Blueprint. So they show up, they're not [indiscernible] Pega goods has their name on it, being able to actually show organizations that we would have never talked to because we're still very focused on our high-end clientele. We're trying to use that to see if we can open the aperture. I think it could be very exciting.

It's a good segue to what I was going to ask, which is we've talked about the established categories and the verticals where you have a strong presence and you've been there for a long, long time. Where should you be that you're not today? Like where can you take this?

Well, I think the issue is less verticals because we are in lots of verticals. And candidly, the power of AI brings a lot of vertical intelligence even in areas where we don't have it. So we've got our intelligence that's in there, but it's really remarkable what -- if you go out to ask the Internet, what's the best way to do these processes and then you know how to incorporate those safely at design time, you have a tremendous amount of power, and that's exactly what Blueprint does. The real thing this lets us do is operate in businesses that are outside the Fortune 1000. We really have only sold to a very, very limited clientele. We've built a $1.5 billion-plus business on the back of that, which -- but there are a lot of other companies. There are lots of $5 billion, $10 billion, $15 billion companies that don't make our current filter. And now we went to our partners and said, we're opening this aperture up, and I think it has the potential to be very positive.

I think one specific vertical, so to speak, that we are probably underserving in terms of the opportunity is the public sector. I mean I think there's not a government and certainly the U.S. government is probably worse than some. There's not a government out there that has modern technology. They have legacy stuff everywhere. I mean we have clients of ours that we see the way that they need to interact with 3 old systems just to be able to tell somebody what a claim amount is going to be. And like it's just ridiculous, almost embarrassing, right? And I do think that there's a big push for -- even from the legislature for constituent management and constituent happiness, like people feeling like I can talk to an agency and actually get an answer. So I think there's that. I also think there's a tremendous amount of that's happening in these agencies. And it's no surprise that we're not going to be able to spend at that level. The U.S. isn't, right? So we got to figure out ways to modernize applications to -- and let the aging workforce not be replaced with the next workforce to support these agent systems. So that to me seems like a great vertical.

And the very powerful agentic capabilities that we have, and there's so much agents speak going around. I'm almost loath to give the term. But we have this amazing approach that turns every workflow into agentic automation. We're using the workflows to drive the agents. You don't have to create these prompts and this other hallucinatory stuff. And that allows actually our existing customers to take work that they had done years ago and be able to make that agenetic without having to go and rewrite it all. And I think we'll be able to do huge things in government, but lots of other businesses. The cost of delivering IT and IT services has the potential to be very meaningfully less. And we think we're well positioned to ride that.

Yes. Yes. We've covered a lot of ground. Our meter is running out on us, but maybe just as a concluding thought. You look out 2 to 3 years, and what excites you most about the opportunity for Pega, the market? And kind of what do you want investors to leave here with today?

Well, I think that if investors really want to understand, they should do a Blueprint. It's available for free. It is game changing. Peter Welburn, our VP of Development goes around and spend all his days working with investors doing Blueprints. And as he said, if I can do them, then you got to believe that anybody can really change it. And I think if you see it and you realize what it's doing, it's a pretty compelling and differentiated story, not just we're a little bit ahead, but that we are structurally differentiated. And that's what I'm excited about.

Yes. Excellent. That's probably a great spot to leave it. Thank you, the Pega team for being here. Obviously, the business continues to perform well, march towards those cash flow goals, and everyone will be very happy.

And DJ, you're not being replaced by ChatGPT.

Yes. Thank you. Thank you guys.

Thanks.