Pegasystems Inc. (NASDAQ:PEGA) Q1 2023 Earnings Call Transcript

Pegasystems Inc. (NASDAQ:PEGA) Q1 2023 Earnings Call Transcript April 26, 2023

Pegasystems Inc. misses on earnings expectations. Reported EPS is $0.23 EPS, expectations were $0.37.

Operator: Greetings, and welcome to the Pegasystems First Quarter 2023 Earnings Results. As a reminder this conference is being recorded. It is now my pleasure to introduce your host Kenneth Stillwell. Please go ahead.

Kenneth Stillwell: Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q1 2023 earnings call. Before we begin, I’d like to read our safe harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, projects, forecast, guidance, likely and usually or variations of such words or other similar expressions identify forward-looking statements, which speak only as of the date the statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties.

Actual results for fiscal year 2023 and beyond could differ materially from the company’s current expectations. Factors that could cause the company’s results to differ materially from those expressed in the forward-looking statements are contained in the company’s press release announcing its Q1 2023 and full year earnings and in the company’s filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 31, 2022, and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements, and there are no assurances that the matters contained in such statements will be achieved. Although subsequent events may cause our view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise these forward-looking statements, whether as the result of new information, future events or otherwise.

And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Alan Trefler: Thank you, Ken, and thank you to everyone on today’s call. We had a terrific start in 2023. Our team executed our strategy well, leveraging our strengths, and remaining resilient in an environment that we expect will remain uncertain for some time. In Q1, we achieved ACV growth of 15% driven primarily by increasing our footprint in our existing clients, and through strength in Pega Cloud. This is exactly what we said we had tremendous opportunity, and where we should focus our sales and marketing efforts. We also saw select new logos. Though that’s not our focus for this year. Clients are responding positively to our architecture, our model, our focus on deep engagement. Pega Cloud is driving growth, and cloud margins continue to scale.

It’s great to see us continuing to make solid progress towards becoming a rule of 40 company, balancing growth with fiscal discipline and generating significant cash flow. Overall, our results reinforce the effectiveness of our strategy. And we see tremendous opportunity for growth. Ken will discuss our financial results in more detail in a moment. Now, I’m spending a lot of time with our clients, both at our Cambridge based Executive Briefing Center, which continues to be solidly booked and on the road, including a trip to Europe I’ve just returned from. I continue to hear the same themes. Last week I was in Germany, Italy and Sweden visiting clients. And despite the anxieties in Europe, the conversations I had were optimistic, and clients continue to be deeply interested in building relationships with Pega.

Digital transformation remains a driving force as organizations are looking for solutions to better deliver personalized engagement and optimize business processes. just published a spending survey that noted that digital transformation was one of the top investment priorities for CIOs in 2023. Pega has a long history of helping clients improve efficiency and effectiveness as well as to improve their customers experience. Clients are also very interested and in some ways concerned about the use of AI, especially with the newest generative technologies. They want to know how to leverage AI in responsible ways to drive automation without compromising enterprise governance or losing control of outcomes. Our approach to digital transformation and to AI is perfectly aligned to both addressing these concerns and meet these needs.

Now to talk about our approach, our three point in developing software has always been about building technology that serves business people. We provide the most powerful and scalable low code platform for AI powered decisioning and workflow automation. We make it simpler for enterprises to work smarter, unified experiences and adapt quickly. And we ensure that organizations can empower their employees without compromising enterprise IT integrity. We’re combining AI and automation to enable organizations to become autonomous enterprises that self optimized with business goals without sacrificing control. Now, as you’ve no doubt seen, there’s an elevated interest in AI and lots of excitement and hype. And just as a reminder, since our founding four decades ago, Pega has helped enterprise clients use our AI powered solutions to automate complex business processes, improve customer experience, and drive operational efficiency.

We’ve been evolving our capabilities as the technology and our clients’ needs are evolve. And we’re in a unique position to lean on this heritage of harnessing, understanding and leveraging AI to be able to provide unique capabilities to our clients. When we announced our generative AI plans last month, we stay true to our approach with an offering that will allow clients to use the generative AI technology of their choice with enterprise governance to make generative AI truly enterprise ready. We focus on building out used cases that maximize value and minimize risk. For example, we use generative AI to create better performing marketing copy or to generate prototype applications from just a simple sentence. Our approach incorporates auditing and human approval that are the hallmarks of Pegas platform.

This manage architectural foundation provides organizations with safety, security and reliability, suitable for the enterprise. IT managers will be able to integrate their own specific generative AI APIs into Pega infinity, and centrally manage licenses and controls to give clients flexibility to add existing or emerging generative AI APIs. A great example of our generative AI strategy coming to life is our recent inclusion in Amazon’s announcement of Bedrock, a new AWS cloud service that allows developers to build and scale generative AI applications in the cloud. Because of our approach, we can easily integrate Bedrock into our platform, and have used cases and make it available to clients. At the same time, we can continue to support other cloud providers and other generative AI solutions based on our client’s preferences.

Now, we’ve been at the forefront of providing responsible AI for years and are committed to putting the controls straight into our software to make sure that fairness and transparency and robustness all exist. We believe that rapid generative AI developments will make lower and low code providers a commodity. But on the other hand, the higher end, enterprise grade solutions like Pega are going to benefit. So we’re excited about the opportunity to create additional value by augmenting our solutions for organizations. Now, we have also rolled out Pega cloud enhancements, supported by an enhanced global operations center that improves speed, scalability, agility, reliability, and security. These improvements help organizations maximize the technology investments and deliver better experiences for staff and clients.

And we’ll continue to make progress with Pega Launchpad, which we announced last year as our new cloud based low code application development platform that empowers software providers to build and commercialize, or post-centric business to business apps. We’re excited to be working with a select group of amazing early adopters, these Pega Launchpad powered apps are being built to address the needs of new markets that they will be pursuing. Now, we’re coming up on PegaWorld Inspire our annual tradeshow and it’s going to be fabulous. We’ll be showcasing our new AI capabilities announcing several new offerings and demonstrating solutions at more than 40 partner booths, and featuring over 200 demos in 100,000 square feet of pure ingenuity. We’re also be highlighting the success stories from more than 40 clients, including outstanding keynote presentations from Aflac.

Photo by Danial Igdery on Unsplash

We will talk about how they are using Pega to reduce roadblocks and bottlenecks and manage staffing fluctuations and market pressures to continually deliver transformational outcomes. Citibank, one of our very first Pega clients, who went live originally, obviously on very different technology in 1984 is using Pega to deliver on its mission of being a trusted financial services partner, leverage decision science to drive omni-channel customer centric experiences. Rabobank from the Netherlands, who will demonstrate how they are revolutionizing customer experiences using our low code and AI capabilities, and Virgin Media, who will describe their journey to become a fully digital business, leveraging Pega’s customer service case management and AI based decisioning.

If you haven’t yet, please check out the PegaWorld website, register and join us to hear and see all of this in person and especially feel free to join us for the investor session on Monday, June 12. Telling summary, I’m pleased with our strong shot in 2023 and our ongoing progress to be a Rule Of 40 Case Company. Our results continue to be driven by ongoing demand from large global enterprises and for digital transformation solutions that drive automation and leverage AI. Our strategy to focus on effort on meaningful clients is proving effective. And candidly is making us feel really good about how we’re doing in the market as well as obviously winning business. We expect to face macroeconomic challenges in 2023 but I think we are well prepared and experienced with executing and challenging times.

I feel confident that we are in the right space with the right capabilities and the right team. And our strategy is absolutely the right one to leverage the significant opportunity in front of us. To provide color on our financial results let me now turn it over to our COO and CFO Kenneth Stillwell.

Kenneth Stillwell: Thanks, Alan. Given an uncertain economic environment, it is great to see our team deliver such a strong start to 2023. The three most important metrics to measure the success of our business are annual contract value, ACV, cashflow, and backlog. So I’m going to focus my initial comments today on how we’re progressing against these three critically important metrics. ACV grew 15% in constant currency year-over-year in Q1. Annual contract value growth has been and continues to be the most important metric for us. This strong result was powered by Pega Cloud ACV growth, which increased 24% in constant currency year-over-year. Pega Cloud represented approximately 67% of the $45 million of net new ACV added in the quarter and constant currency.

Pega Cloud ACV continues to be the largest ACV component and the fastest growing. Our ACV growth was bolstered by our decision to realign our go to market strategy and focus our resources on deepening our relationships with our marquee customers. Our first quarter results provided clear evidence this strategy is working. Our ACV growth was broad based and in addition, we are attracting new logos. Although that is not our primary focus for 2023. Moving to cash flow. In Q1, we generated $68 million in operating cash flow to produce $75 million in our free cash flow metric which is a great start to 2023. We still have a lot of work to do for the year though. When we started our subscription transition in late 2017 our vision was to transform Pega’s economic model and build a successful business for the long term while delivering tremendous value for our clients.

Our strong ACV growth coupled with our strong free cash flow generation is the result of many years of hard work by our team to sharpen our growth strategy and efficiency. We’re now running the business as a subscription business. We’re really happy with the success we’ve had anchoring the concept of efficient growth. And as you can see some of the results are starting to show as we progress through the first quarter numbers. We expanded Pega Cloud gross margin to 72% and we’re increasing our operating leverage and we believe there’s more upside to our Pega Cloud gross margin in the future. Moving on to backlog. Total backlog increased by 14% year-over-year in constant currency to $1.34 billion driven by growth in Pega Cloud backlog. Revenue had two thirds of our net new ACV add from Pega Cloud in Q1 and that drive that combined with a lower number of term license renewals, we obviously would recognize less revenue in the quarter than we did last year in the first quarter.

That’s because the majority of revenue from term license deals is recognized upfront and upon renewal. In contrast, Pega Cloud revenues recognized ratably over time. Given these dynamics, revenue and non-GAAP EPS and an individual quarter can be highly variable. And sometimes it’s not representative of the underlying fundamentals of what’s happening in the business. For example, total revenue in Q1 was down 14% year-over-year driven by this 39% drop in term license revenue. We discussed this back in February. Our term license backlog was unusually high at $172 million in the fourth quarter of 2021. And you saw that backlog significantly impact revenue in the first quarter of 2022. Given that our term license backlog balance at the end of 2022 was significantly less than the prior year, we expected term license revenue in Q1 of ’23 to decline significantly year-over-year.

We also repurchased $33 million of our $600 million convertible notes and approximately a 10% discount. This transaction was not part of a formal repurchase policy rather, as we generate cash, we will look to opportunistically retire our convertible debt. Similarly to last quarter given an uncertain economic environment, we thought it would be helpful to provide some thoughts on modeling our business. Our practice is to provide annual guidance at the start of the year, and not to update guidance unless we’ve done a material acquisition or something else materially happens in the business like we mentioned last year we do not provide quarterly guidance. Given our focus on increasing cash flow, we added a new metric this year free cash flow. Our commitment to generating free cash flow is strong.

As a company, we understand the value especially in an uncertain growth environment of delivering both consistent free cash flow generation and free cash flow improvement as we scale. That way, when we actually see these periods that are less certain in the growth environment when the economic climate is not as welcoming we established a solid free cash flow based business. And as we expect our sales and marketing expenses to be higher in the first half of 2023 compared to the second half that’s driven by our PegaWorld Conference being live in 2023 and as we’ve mentioned, as Alan mentioned earlier, for the first time since 2019. I’m very excited that our investor session will once again be held in person in Las Vegas after a four year virtual sessions.

Monday, June 12, at PegaWorld, we will host investors to discuss our long term model and our long term strategy. If you’re interested in registering for the investor session, please email pegainvestorrelations@pega.com. The agenda will include updates on our go to market strategy, our product innovation, and also our financial model. We will also include time on the agenda as usual for questions and discussion. In closing, our team executed very well in the first quarter of 2023. Of course, we’re still facing with all of our other participants in the software market uncertain economic environment. So we’re going to continue focusing on those three most important metrics as I mentioned, ACV, cash flow, and backlog. Operator, please open the line for questions.

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Q&A Session

Operator: Thank you. We will now be conducting a question and answer session. Your first question comes from Kevin Kumar with Goldman Sachs. Please go ahead.

Kevin Kumar: Thanks for taking my question. Kenneth the guidance provided last quarter for 2023 I believe factored in some softness in the macro environment. Have you seen anything materialized in terms of lengthening of deal sales cycles or changes to close rates? Or have those held up relatively well?

Kenneth Stillwell: Yes, Great question, Kevin. So there is a couple aspects of that. So the first one is, in terms of our team executing against our sales campaigns in our pipeline, I think I wouldn’t say there was any deterioration that we saw in Q1. I think we executed well. I think our clients are still engaging. There is very committed to their digital transformation initiatives. That said you can definitely sense that there’s some level of economic concern out there as there was last year, but I think our execution against our pipeline was solid. So I think there’s two pieces of that. The execution was good, but you can feel the uncertainty or the kind of the timidity that’s out there in the marketplace. But we haven’t seen that translate into actually like statistical deterioration of our close metrics.

Kevin Kumar: Yes, that’s helpful. And then curious on the comment on logo adds. I know the focus has been more on expansion within existing customers, and there’s been some changes in the sales organization to focus on that. So what was that kind of the natural course of the sales process? And just curious those remaining for contributors .Thanks.

Alan Trefler: Well, it’s Alan. We do get inbound customers, meaningful organizations, that either have somebody who’s worked with us somewhere else, or see what leading companies are doing in the various industries. And those are the basis of how we are and will in the future, be adding new logos because, well, that’s very consistent with our strategy. I will tell you that by giving ourselves the capacity to spend a lot more time with several 100 customers that are critical to us and we have significant relationships with we have absolutely uncovered the opportunity types that we had expected working with those companies and see both the upside, and candidly are really, I think, building and continuing to improve great relationships with very important organizations. So the strategy feels really good particularly in a year that’s maybe a little tougher.

Kenneth Stillwell: I would also add one other point to that which is, I wanted to be very clear, because I think that there are some people that heard the message of our strategy that we were not entertaining new logos or that somehow new clients were not important to Pega. That that is not true. It’s just not where the majority of our focus is, because we think the opportunity is with our existing clients. But as Alan said, there are lots of companies out there that look just like our clients that are not current clients of Pega. And sometimes we find them and sometimes they find us and I think that will continue to happen. I just wanted to make sure that nuance was clear.

Kevin Kumar: Great. Thank you both.

Kenneth Stillwell: Thank you.

Operator: Next question, Rishi Jaluria with RBC. Please go ahead.

Richard Poland: Hi, this is Richard Poland on Rishi. Thanks for taking my question. So I guess the first one is a two part question around generative AI and kind of what you’re doing on that lane. So it sounds like a lot of the value proposition is the security and compliance that you’re kind of wrapping around some of the AI technologies. And it’s really exciting opportunity. But just kind of if you could just elaborate a little bit on how you’re differentiating against the other generative AI type solutions out there and then just a follow up on that is just how you think about the monetization opportunity long term. Thanks.

Alan Trefler: Sure. So I think we’ve got a structural advantage compared to lots of other companies. Because Pega has always been a model driven company. What that means is you create a model of how you want your business to run. And from that model, our system actually writes the software. We’re using the generative technology to basically inform the model. So for instance, you can say, hey, I want to define a process for home equity loan. And generative AI will do a terrific job of identifying one of the stages you would go through, what would a schema, data schema look like that would capture the information that you would need, what would for example sample data look like. You might use to be able to test it. And all of those are components that go into our model.

It gives you such an amazing opportunity to really jumpstart, but also simplify a lot of things about how you apply technology to your business. So those are the types of examples; things that really leverage, an architecture that I think is extremely well suited and candidly, a lot of the companies have been talking about low code. I think are in enormous trouble because low code apps that don’t fit a real enterprise standard, and don’t have the right structures. I think in many cases just going to be replaced by people using generative AI to write the code but there’s a huge market for things that are a little more sophisticated, need to be updated routinely. So you don’t just do it once and use it, but you want to be updated, updated, again, updated six months later.

And those are the types of things that I think we have a structural advantage for towards what we are doing. Monetizing it, I think this is absolutely going to drive additional demand for Pega and a variety of use cases. And with our clients in general, when they use our software more, it gives us a chance to get paid more. And that’s good for them. And it’s good for us. So I think that this has candidly a lot of appropriate excitement in addition to the hype, we feed, which is nonstop, but we’re not affected by that. It’s just part of I think having a pretty mature understanding of what AI is about. And we were on this technology long before it broke into mainstream media.

Richard Poland: Thank you, Alan. That’s super insightful. And then maybe one for Ken. Just as we think about the pace of Pega Cloud gross margin expansion, and it’s been really solid in the past recent years. How should we think about that kind of going forward? I know, one of the previous targets, I think was in the mid to high 70s range by 2025. Is that kind of the track, we should still think about Pega Cloud gross margins? Thanks.